Hedging with Binary Options – Simple Risk Management

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Hedging With Binary Options

Binary options are a growing form of investment, simplifying the process of trading for many investors – but does the simplicity of a binary option open up opportunities beyond an introduction to trading? Could they, for example, be an ideal tool for risk management and hedging other investments ?

Define Hedging

A hedge, in terms of investment, can be loosely defined as;

“An investment made to mitigate risk in the event of adverse price movement of an asset.”

So hedging is a risk management strategy, offsetting an existing position in a related asset, or group of assets.

The most obvious “real world” example is an insurance policy. The policy protects the holder in the event of a particular event. In order to secure this protection however, the policy holder must pay for it. So a homeowner might insure their property, knowing that in the event of the property being damaged or destroyed, they would receive compensation. The trade off is that were nothing to happen to the property, the regular insurance premiums would erode some of the capital gains made.

The aim of hedging an investment then, is to mitigate any potential losses. Either from a particular event, or simply volatility. An investor may be cautious of a future event and wish to protect their investment. Simply closing and re-opening a position is not always easy, or cost effective. A trader may wish to continue holding their position, but simply apply some risk management.

This risk mitigation exercise could be necessary for a variety of reasons. A specific announcement, a global or domestic crisis, a key vote or any event – known or otherwise – that might affect the value of an asset.

How to hedge with binary trading

So given the fundamental aim of hedging an investment – could a binary option offer a flexible method of hedging? With costs, and potential returns, established before the trade is placed, traders can manage their level of risk with huge accuracy.

A hedged trade using a binary option

Let us look at a simple, fictional, example;

Our trader has a large holding in HugeCorp Plc. There is a concern that an upcoming court ruling regarding a patent will significantly affect the share price, perhaps knocking 10% off the current value. The trader is confident the ruling will be made in favour of HugeCorp – but wants to mitigate the risk.

Our trader opens a binary trade – with an expiry date shortly after the date of the ruling. If the price is below today’s value at the point of expiry, the trade will return 95% on his investment. If the price on expiry is above today’s valuation, the binary option will lose. The size of the option can be tailored however the trader chooses, enabling the risk to be managed to a precise level.

Our trader has mitigated the risk of any adverse news. Should the ruling go against HugeCorp, the option pays off – reducing losses. If the news is good, the binary option will lose – but the original holding in HugeCorp will have risen in value, mitigating the small loss on the binary option trade.

A binary option then, can provide an excellent hedging tool, particularly when considering a specific event, where the date is known. More elaborate options could be used, beyond the simple Higher/Lower type. For example an In/Out option might be used to protect against flat markets or delayed events.

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Finding The Right Broker

In order to use binary options for hedging purposes, traders need to be very selective with their broker choice. A fundamental part of the hedge will be the time frame. The majority of these ‘hedge’ investments will be longer term, or for a specific event. Either way, the trader will require a large element of flexibility from their broker. Some brokers will not provide long term expiry times at all, others may provide ‘set’ long term expiries, for example, 3 months from today’s date, or 6 months. Binary.com however, allow traders to set their own expiry date – any date they choose. This level of flexibility means traders can be very specific and ensure their positions expire exactly when they need them to – for example directly after a key announcement.

In summary then, binary options are a great tool for those traders wishing to hedge related investments. The absolute control of the value and expiry date of the trade, make them perfect for risk management as potential losses and gains are known at the outset with absolute accuracy.

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:

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.

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  • Binomo
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