What is hedging binary options strategy and how to use it

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How to Hedge Stock Positions Using Binary Options

Binary option trading had been only available on lesser-known exchanges like Nadex and Cantor, and on a few overseas brokerage firms. However, recently, the New York Stock Exchange (NYSE) introduced binary options trading on its platform, which will help binary options become more popular. Owing to their fixed amount all-or-nothing payout, binary options are already very popular among traders. Compared to the tradition plain vanilla put-call options that have a variable payout, binary options have fixed amount payouts, which help traders be aware of the possible risk-return profile upfront.

The fixed amount payout structure with upfront information about maximum possible loss and maximum possible profit enables the binary options to be efficiently used for hedging. This article discusses how binary options can be used to hedge a long stock position and a short stock position.

Quick Primer To Binary Options

Going by the literal meaning of the word ‘binary,’ binary options provide only two possible payoffs: a fixed amount ($100) or nothing ($0). To purchase a binary option, an option buyer pays the option seller an amount called the option premium. Binary options have other standard parameters similar to a standard option: a strike price, an expiry date, and an underlying stock or index on which the binary option is defined.

Buying the binary option allows the buyer a chance to receive either $100 or nothing, depending on a condition being met. For exchange-traded binary options defined on stocks, the condition is linked to the settlement value of the underlying crossing over the strike price on the expiry date. For example, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from the option seller, taking his net profit to ($100 – option premium paid). If the condition is not met, the option seller pays nothing and keeps the option premium as his profit.

Binary call options guarantee $100 to the buyer if the underlying settles above the strike price, while binary put option guarantees $100 to the buyer if the underlying settles below the strike price. In either case, the seller benefits if the condition is not met, as he gets to keep the option premium as his profit.

With binary options available on common stocks trading on exchanges like the NYSE, stock positions can be efficiently hedged to mitigate loss-making scenarios.

Hedge Long Stock Position Using Binary Options

Assume stock ABC, Inc. is trading at $35 per share and Ami purchases 300 shares totaling to $10,500. She sets the stop-loss limit to $30—meaning she is willing to take a maximum loss of $5 per share. The moment the stock price falls to $30, Ami will book her losses and get out of the trade. In essence, she is looking for assurance that:

  • Her maximum loss remains limited to $5 per share, or $5 * 300 shares = $1,500 in total.
  • Her pre-determined stop-loss level is $30.

Her long position in stock will incur losses when the stock price declines. A binary put option provides a $100 payout on declines. Marrying the two can provide the required hedge. A binary put option can be used to meet the hedging requirements of the above-mentioned long stock position.

Assume that a binary put option with a strike price of $35 is available for $0.25. How many such binary put options should Ami purchase to hedge her long stock position till $30? Here is a step-by-step calculation:

  • Level of protection required = maximum possible acceptable loss per share = $35 – $30 = $5.
  • Total dollar value of hedging = level of protection * number of shares = $5 * 300 = $1,500.
  • A standard binary option lot has a size of 100 contracts. One needs to purchase at least 100 binary option contracts. Since a binary put option is available at $0.25, total cost needed for buying one lot = $0.25 * 100 contracts = $25. This is also called the option premium amount.
  • Maximum profit available from binary put = maximum option payout – option premium = $100 – $25 = $75.
  • Number of binary put options required = total hedge required/maximum profit per contract = $1,500/$75 = 20.
  • Total cost for hedging = $0.25 * 20 * 100 = $500.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

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Binary Options Trading Hedging Methods

In this article I am going to discuss and explain you some hedging methods that you can try with Binary Options contracts.First of all, I want to explain what is exactly hedging. Hedging is a way to reduce the risk of your trades. It can give an “insurance” to a trader and protect him from a negative movement of the market against him.Of course, it can’t stop the negative movement but a clever hedging can reduce the impact of the negative movement for the trader or it can even annihilate the impact of the negative movement for the trader.Hedging methods are applied every day to the market by the traders to give a “sure profit”. This profit is usually not very big but it’s steady with low risk.

A very popular hedging method in binary options trading is “the straddle”. This strategy is not easy because it’s difficult to find the righ setups. It’s a strategy about two contracts with different strike price to the same asset. Let’s see a screen shot.

This binary option chart is from GBPUSD currency pair. The general idea of this strategy is to create bounds for the same asset with two contracts. To create an ideal straddle you must find the higher level of a trading period and take a call and the lowest level of a trading period and take a put.That’s why this strategy is not easy, because is a difficult to predict the highest and the lowest level of a trading period. A good trading period for straddle is when the price is moving inside a symmetric channel like this. There is not much volatility to create unpredictable situations. So, look at the chart. We have a previous resistance and a previous support. When the price hit the resistance which the highest level for now we can take a put with 15 minutes expiry for example. After that the price is moving down and hit the previous support which is the lowest level for now. In this level we can take a call with the same expiry, 15 minutes.

Now let’s see the possible scenarios.

1 st scenario: The put contract expires after the reversal in the support and it’s in the money.Five minutes ago we took a put in the support which expires in the money,too. So, in the first scenario we have 2 ITM trades with a high reward.

2 nd scenario: In the second scenario our first put trade will be in the money but let’s assume that the support will not stop the price for our call like the next time that the price test the support in the chart. So, we have an ITM put and an OTM call. This means a very small loss for us.

So, if a trader will create a good straddle the possible scenarios are a high reward or a very small loss.

Some more binary options hedging strategies

These strategies are mainly for binary options trading in an exchange and are about hedging the same or different assets.

GBPUSD and USDCHF are two currency pairs which usually moving opposite to one another. Let’s see two screen shots.

This is from GBPUSD currency pair. You can see that at 12:25 the GBPUSD is moving up and about 50 minutes is still moving up.

Now, this USDCHF currency pair chart and you can see that the same time(12:25) the price is moving down and about 50 minutes is still moving down.

So, there are opportunities to trade this. I usually open 2 trades (one in GBPUSD and another one in USDCHF) in Spread Betting or Spot Forex with the same direction. You will win one of them for sure.For being profitable with this you should find the right time in which these two currency pairs give you a profit.For example in this chart we can open two sell orders.Even in first 10 minutes we will have profit because the downtrend in USDCHF is stronger than the uptrend in the beginning.

This is a trade I took which gave a 36$ sure profit. For doing this in Spot or in Spread Bets you must have a good margin in your account.

These two pairs EURUSD and GBPUSD are moving in the same direction. You can hedge them in a binary options exchange.Let’s see an example.For the example we will use 2 five minutes contacts in these 2 currency pairs.The contracts are opening for example at 10:00 and the expiry is at 10:05.We are buiyng a call contract for the one of them and a put contract for the other.The premioum for the both of them are 100$ because we are buying at the beginning before the price move.(50$ for EURUSD and 50$ for GBPUSD).After some minutes the market has moved to one direction up or down. One of our contracts will ITM and the other OTM. Now, for example at 10:03 we are closing the OTM contract with a small loss like 20$ the most of the time and there are 2 minutes left for the winning contact to expire. The contract will expire and we will earn 100-50=50$

50-20(our loss)=30$ sure profit if will not happen an unpredictable movement in the market like a big candle of 3 or 4 pips.

Advanced Hedging Strategy

Money management is one of the crucial things that you need to apply while trading options. During your binary options education as well as trading you can come across many different strategies that will confuse you.

Talking about hedging strategy in particular, it can turn out to be very useful if in the right hands. In fact, it enables traders to mitigate the further risks of loss due to traders’ own mistakes caused by bad decisions in the past. Indeed, potential profits are cut as well.

How Hedging Strategy works?

In order to explain the mechanism of hedging, we suggest referring to the practical example.

Say that at 8:00 GMT you are going to buy Call option on the USD/JPY currency pair at 120.25 strike with a respective price of $86 and an expiration at 9.00 GMT the same day. So, in case of successful outcome the payment (considering the fact that at midnight the price will be higher than 120.25 for any value) will be 75% or $64.5. In case of fail, you will get from the best broker a refund of 10% or $8.6. After a while, you observe that at 8:30 GMT the price of USD/JPY is 120.35.

Now you will see how one currency pair hedging comes handy. Based on the example above, if you presume that it is possible for the further progress to be changed in the completely opposite direction, then you will have to buy a Put option of the equivalent amount and with the same expiry period at the new strike price.

Therefore, you are creating a sort of corridor in which the price is expected to move.

Hedging Strategy – possible outcomes

Our situation has three potential consequences at 9:00 GMT:

The price of USD/JPY is lower than 120.25. Thus, first Call option is lost and the Put option wins. So, the net profit will be $74.5 (meaning $64.5 for profit trade + $8.6 refund of loss). Your overall investment here is $172 and you have $11.5 of net loss from the two deals.

Second outcome is that the price of USD/JPY continues to grow. Then, by the 9:00 GMT the price is above 120.35. We have the following results: the first Call option wins and the Put Option is out. The payment is $159.1 in total ($150.5 + 8.6 refund of loss). Hence, you have invested $172 and the result is $11.5 of the net loss from two deals.

The last consequence is that the price of USD/JPY is between 120.25 and 120.35, which means that both deals are successful for you. So, the total payment will be $301, as you receive $150.5 for each of the two trades. Considering the investment of $172, the net payout in this case is $129.

How can we actually hedge with lower risk?

We can definitely say that before any deal it is advisable to look at the market behaviour and choose the most proper time to trade. Hedging can still bring some loss as we can observe in the first two outcomes of the example. Only in the third case you doubled your profits.

Nevertheless, you should buy the second option solely if the price reached a particular level of support/resistance. Additionally, if a sudden change occurs due to news publication or particular events, then buying the second option will be a wise decision too. Essentially, such a case of price adjustment in the opposite direction takes place. This is why it is supposed to make a profit rather than loss.

There is an alternative way to hedge. You can open the option for an asset other than your main one, over which the insured transaction is performed. As the matter of fact, there are multiple assets for which the price movement is either synchronized or simply goes in opposite directions.

Let’s look at this from the practical point of view. If you have bought a Call option on EUR/USD pair, it is possible to diminish the risks by buying a Put option on USD/CHF. The reason for this is simple – both pairs move quite synchronically.

Summary of the hedging strategy

This strategy requires a substantial amount of experience in the online trading and deep understanding of the financial markets. That is why only advanced traders can use the hedging strategy in the appropriate way. You should not be hurry with your decisions. Therefore, prior to trading the second option you are highly recommended to wait for the price to reach a specific level of support/resistance or wait until an abrupt change caused by significant economic data release.

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