Hedging – will minimize your binary options losses

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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:

Binary Options Hedging Strategy

Binary options traders use hedging to ensure profits and reduce risks especially when volatility is high or market conditions become more unpredictable. Fluctuations in the market can cause trades that are seemingly successful to turn around unexpectedly. Hedging is used to figuratively trim off the price that will allow traders to trade in boundaries, making the cash flow more manageable.

Hedging has been used as a general trading strategy but is relatively new to binary options trading which introduced to the markets a few years ago. Hedging strategies quickly gained momentum for the reason that it is easy to understand and implement. One of the major features of hedging is their ability to extract the maximum benefits from the fundamental structure of binary options while minimizing loss.

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Particularly, hedging allows binary options traders to take advantage of the fact that binary options only result to two possible outcomes when a trade expires. The success of hedging strategies for binary options depends on knowing the right time to execute the trades. Learning the precise moment to execute the strategy will minimize the uncertainties that can come up during the period of the trade.

Binary options trading was developed with simplicity in mind. However, trades still harbor an innate degree of risk. This is the reason why experienced traders recommend that new ones should only trade this new investment vehicle by using a sound and trusted strategy. This is also where hedging becomes an advantage because it is ideal for all traders, especially novices. Traders will be able to substantially increase their profits while minimize their risk in doing so.

Someone who is new to binary options would find that one of the best courses of action you he take is to learn how to use hedging strategies effectively. A new trader can quickly make up for his lack of skills and knowledge by implementing the strategy correctly. When a novice trader takes up strategies that involve hedging, he is able to learn more strategies that involve multiple trades and risk reduction.

Basically, there are only two possible outcomes that can result whenever a binary options trade has been made. A trader can either suffer a predetermined loss or succeed a predefined gain. Because of this, the risks involved are great especially that financial markets can experience high levels of volatility that can generate sudden price surges with practically no warning whatsoever. Such events can cause profits to turn into losses in the blink of an eye.

We have discussed many strategies to minimize these risks. In addition to those strategies, experienced traders recommend using hedging strategies. This effectively minimizes risk exposure while securing profits. Below is an example provided, so that new binary options traders may use it as a blueprint in coming up with their own strategies. Bear in mind that new traders need to perform this in a demo account first, before going live.

Example

Hedging in binary options is one of the easiest strategies to implement. Expert traders may have derivatives of this strategy, but the basics still stand. Furthermore, learning the foundations of hedging can branch out to other strategies that the new binary options trader can use. Because there are many ways in which hedging can be implemented, let us consider a popular method that entails combining both Call and Put binary options.

Let us use a hypothetical trader who chooses to trade FOREX particularly the Euro USD pair. Imagine that the binary options trader just received the following tip from his binary options broker. EUR/USD currently has a bearish bias with a put option price beneath 1.3650 and a call option price of 1.3350. Imaging the trade to expire in one hour and the price slipped under the 1.3650 level at 10:30 am EST.

The trader now decides to purchase a Put option based on EUR/USD. He first selects an expiry time at 11:15 am EST then deposits a wager of $100. This sum is 2% of his entire account balance and is in accordance with his money management strategy. The trader sees that the payout for trades is 75% and that no refund will be given for ones. His ratio at execution is therefore 80%:100%.

With about 15 minutes before expiration, the trader sees that the currency price has declined and that his trade is presently . However, volatility is high and the price is presently registering an oversold condition. In addition, the trader notices that price is beginning to rally so that it could possibly threaten his position by expiration. What can be done to protect his gains? The answer would be hedging.

By purchasing a CALL binary option with the same parameters as those of the original Put option, that is, same asset, expiry time and wagered amount, hedging can be performed. The trader now creates a new window of opportunity bounded by the opening prices of his Put and Call binary options. Consequently, the trader could possibly collect a double return if the price finishes within this range at expiration.

Even more importantly, the trader could have minimized his risks as the profit from the winning trade would practically negate the loss of the trade, should price fall outside this window when the expiry time elapses. As such, the reward– ratio now becomes $150:$20, which is an obvious improvement compared to when hedging is not performed. Instead of losing $100, winning $80 would mean that he would only lose $20.

As you can see from this example, using a hedging strategy is a simple yet very effective tool which can both secure your profits and reduce your risk exposure at the same time. As the financial markets can change drastically in volatile environments, you will find that mastering how to execute such a strategy proficiently is an excellent method to counter such unpredictability.

We will continue to provide you with more strategies that will help you improve your chances of success with binary options. In the meantime, you could check out our list of top brokers who can give you demo accounts so that you can practice hedging and use it efficiently.

Using a hedging strategy when trading binary options

October 12, 2020

An important facet in trading is to keep an open, flexible mind about the market. That is, trade what you think the market will do rather than what you want it to do. This is especially hard for those who state or publish their outright opinions on how they envision the direction the market will go. And it’s especially important for those who trade longer-term instruments, in that the refusal to be wrong on a position will likely just lead to the situation become vastly worse. It essentially represents emotional attachment to the market, which is never a positive thing.

How is any of this relevant to trading short-term binaries? Well, occasionally in binary options there comes a point where a call option set-up can transform into a potential put option (or vice versa) without much of a time gap in between.

I encountered a trade scenario on Wednesday that embodied this type of situation:

On the 7:50AM (EST) candle, I was looking to take a put option on the GBP/USD at 1.6016. As we can see, this represented a resistance level with price reaching up to that level earlier in the morning during the first hour of the European session at 3:50AM EST. However, nearly immediately after I took this trade I realized that it would have a low likelihood of working out, as the 1.6016 resistance had been breached. Overall, the trend was up and above the pivot point, which is often taken to be a bullish signal. Moreover, the 1.6000 level had been surpassed earlier in the morning and now with a recent resistance level broken, it suggested to me that it would be most likely to continue its journey upward.

Instead of watching the chart tick for tick and hoping that my put option would come back in my favor (it did briefly), I decided that I was probably going to be wrong and immediately took the opposite side of the market in what’s commonly called a “breakout” trade. I took a call option at the point of the arrow specified on the chart above.

Now I had two trades open, but was far more confident in the second trade I had taken. With five minutes to go before expiration, I was actually winning on my first trade and losing on the second. When looking at the chart at the conclusion of the 7:50 candle, it could give the illusion that there was a “false break” in the market and the pinbar that had formed would most likely mean that the first trade was correct and the GBP/USD would head south. However, false breaks can work both ways. If this was currently a downtrending market, or if the GBP had some fundamental reason to be weak (or the USD had some fundamental reason to be strong), or if there was more resistance just above the 1.6016 level, then I might agree that the false break was probably valid as such and would continue down. But as I stated earlier, this pair had shown a lot of momentum earlier in the morning to breach 1.6000, which is one of the most well-known price levels in all of forex trading. Therefore, movement in the next five minutes was most likely to give me a winner on the call option, which it did, closing out about 2.5 pips in favor.

This is an example of a hedging strategy in binary options trading, although, in general, this is probably going to be something that you use sparingly. You should be relatively well convinced that your initial trade will likely be incorrect before taking the other side of the market in quick succession. While it’s something that is ideally suited to minimizing a loss, if the gap between the ITM zones is large between the entries of both trades (3 pips in my case) then it can give you two OTM trades, which spoils the premise behind entering the second trade to begin with.

While this bullish bias to the GBP/USD was less pronounced during pre-market New York hours, it continued throughout the remainder of the week, as it nears 1.6100 just before the forex markets close for the week.

Hedging Strategies Using Options

Options Bro

When the market starts to tank, there are a couple of things you can do. If you have an iron stomach, you can sit through the turmoil and do nothing and take the chance that prices will recover before your losses become too severe. But you can also be proactive and protect yourself against further declines in stock prices by employing various hedging strategies using options.

Let’s take a look at the two most common ways to hedge long stock positions with options.

Key Points

  • Buying put options on the S&P 500 is a common hedging method
  • Buying call options on the VIX or UVXY is also a way to hedge
  • Always keep your hedges small to avoid a situation where the loss from hedging is larger than your original investment loss
  • Hedging is only intended to mitigate losses, not eliminate them
  • Keep your fees low and use Ally Invest for all options trading because they are the cheapest options broker with 24/7 customer service

Buying S&P 500 Put Options

When most people think of hedging strategies using options, this is probably what comes to mind. It’s by far one of the most simple and effective methods of reducing losses in a long stock portfolio.

Essentially, if you buy a S&P 500 put option, (ticker symbol SPX) you are given the right, but not the obligation, to short the S&P 500 at the strike price of the put option you purchased.

As the price of SPX drops, your long put option will theoretically increase in value. Increases in volatility will also positively affect the value of long put options (more on this later). See the graph below of the profit and loss of a long put.

Put buyers need to be aware of a couple things. First, puts often trade richer to calls due to implied volatility. This is because other market participants realize that stocks usually tend to crash down, not up.

As such, investors are willing to pay a premium for out of the money options that will pay off when the underlying asset declines in price.

Simply put, there are more possible situations where the S&P 500 could crash down 25% in one day then there are where it could crash up 25% in one day.

Buying VIX or UVXY Volatility Calls

When markets are chaotic, some investors prefer to buy volatility itself as opposed to buying put options on stock indices.

Although there are a few different ways to purchase volatility, the most common way is to buy call options on the CBOE VIX Index.

The price of the CBOE VIX Index is derived from the prices of call and put options on the S&P 500 Index. As prices of calls and puts increase, because investors want to hedge their stock portfolios, volatility and uncertainty also increases.

If you buy VIX calls, you will profit when the VIX increases, and when the VIX increases, it tends to do so quite dramatically.

This 5yr chart of the VIX displays how price levels can go from 10 to 25 in only a few days. When the VIX is at 10, and you buy 20 strike call options, and stocks crash and volatility subsequently rises, the long VIX calls will profit nicely. Of course, this is assuming volatility volatility rises and stocks crash, it doesn’t always happen like that.

One of the risks of buying VIX calls is that nothing will happen in the markets and the calls will ultimately expire worthless. However, since the calls were only a hedge, and not a speculative position, the ultimate goal is actually for the calls to expire worthless, because this means your core position of long stocks did not lose value. If the calls appreciate in value, this likely means that your long stock position decreased in value, which is not what you want to happen.

As noted in one of our unusual options reports, institutional investors with hundreds of millions of dollars buy VIX calls to protect their long stock positions.

Buying volatility call options is a proven and effective method for neutralizing portfolio beta and hedging against losses.

Final Thoughts

Without a doubt, one of the core principles of hedging is to keep your hedge size small. This means that the loss of your hedge should never, under nay circumstances, outweigh the loss of your original position that you hedged.

As such, this ultimately means that, in a perfect world, your options hedges will expire worthless and your core long stock position will be profitable. Hedging is merely a way to minimize losses, if they occur. It is not a way to profit from asset price declines.

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