What is Square Position?
A "square position" refers to eliminating exposure to market risk and is normally achieved by closing out all existing positions.
- A "square position" refers to eliminating exposure to market risk and is normally achieved by closing out all existing positions.
- The term "square position" is commonly associated with foreign-exchange trading, but it can be applied to any type of market trade where offsetting positions can be held.
- Foreign exchange market makers, commonly known as dealers, generally seek to square their exposure in the currencies for which they provide liquidity.
Understanding Square Position
A square position is a situation where a trader or portfolio has no market exposure. It is commonly associated with foreign-exchange trading, but it can be applied to any type of market trade where offsetting positions can be held. A square position is also referred to as a "flat position."
Square position, like many trading terms, can take on a different nuance depending on the speaker. For an individual forex trader, a square position can refer to offsetting long and short positions in the same currency pair or a situation where a currency trader holds no positions in the market. The reason for this confusion is that the term "squaring up" is used to describe settling open trades before the market closes. Squaring usually refers to just a few positions, but a trader could close out all of his open positions and get out of the market.
The Why of Square Positions
Square positions have no real market exposure, so there is no real market reward for holding them. There can be transactional costs and interest considerations via a carry trade but, for the sake of simplifying the explanation, we will assume these are minimal. Despite the fact that there is no gain in a square position, there is a reason for a forex trader to enter into one for the purpose of offsetting long and short positions. If a trader is unsure of the direction of the market or a particular currency pair, he can take up a square position and then remove the offsetting position once he is confident in the actual market direction.
There are, of course, more efficient ways to do this rather than holding two offsetting positions. Stop-loss orders, buy limit orders, and other situational trades can be used to set up a hedged position in a similar market situation. The difference between an order-based hedge and a square position is that the order-based approach may result in most of the trader’s capital being pulled from the market, whereas a square position can remain all-in.
Currency Dealers and Square Positions
Foreign exchange market makers, commonly known as dealers, generally seek to square their exposure in the currencies for which they provide liquidity. Forex dealers want to have the buy positions on their books equal the sell positions, so that the dealer is not net long or short. Currency dealers and banks generally have spot market traders who look to eliminate the net market exposure created by engaging in currency transaction by squaring the positions. This way, a currency dealer stays as close to perfectly hedged as possible.