A directional movement hedge

Adding options to a portfolio is a good way to hedge exposure against specific directional movement and/or to earn premium in exchange for limiting one’s profit potential on opposite directional movements.

For example:
You have a long FX position, and want to profit from any further increases in the spot price, but are also worried you will lose your profits if there is a large decline in the spot price.

The combination of a long FX spot position with a Bought Put option can “insure” the FX spot position against price falls.

You bought GBPUSD at 1.60, and the price of GBPUSD has increased to 1.6350. You feel there is still significant upside in GBPUSD over the next month, but are also worried about a fall in the spot price.

You then hedge your downside risk by buying a one month Put option at 1.6350 for the same amount as your spot position. You will pay a premium for owning this option, but have locked in profits if there is a fall in the spot price, and will still benefit from any further upward movement in the GBP/USD spot price above 1.6350.

The advantage of buying a put over a stop loss order is that the stop might pull you out of the position early because of a short term move in the spot price. This will not occur if you have bought an option as a hedge.