Binary options are a fun way to invest in the stock market. The concept of paying all or nothing irrespective of where the market goes simplifies things, making it more analogous to betting on the outcome, in this case, the price at expiration. However, many people are unaware that binary options can be used for hedging and speculation. Some binary options brokers on the FX market advise traders to employ binary options to hedge profitable forex positions and extend profits during minor pullbacks. In this case, hedging involves using binary options so that you only lose a small amount while remaining open to larger rewards.
Binary options include a striking price and a time limit, as short as a few minutes or as long as many hours. A binary call option delivers the specified amount if the price exceeds the strike price at expiration; a put option pays zero. A binary call option is useless if the real price is below the strike price at expiration, whereas a binary put option would pay out the agreed price. The price of the option is determined by the likelihood of the outcome and how far in or out of the money the underlying is currently trading.
Hedging a binary option is purchasing both a put and a call on the same financial asset with price targets that allow both to be profitable at the same time. That is, the binary call option’s strike price is lower than the binary put option’s strike price. “That person is hedging his bets,” we say when we see someone equivocating on a point and trying to safeguard all his options. That is precisely what hedging in trading entails.
What does Hedging mean?
Both the put and call options would be in the money at expiration if the real price were between the two strike prices, and you would make a large profit over your premium outlay. This is the best-case situation, and all it takes is for the price to be in a range that you decide on. To be sure, the bigger the range, the more the binary options will charge you, but that is part of your decision-making process.
However, because you hedged your bet by taking both sides with the call and put, even if the price swings beyond the range, you are not out of the woods. If you choose just one binary option, you’ll lose everything if it finishes out of the money; but, if you use this approach, one of the options will still pay out, cushioning the loss. You’ll still lose money because the premiums are more than the payout of a single choice, but it’ll be a lot less than it could have been.
To summarize, you buy a binary call option, and a binary put option with price targets that overlap to ensure that at least one of them pays out. You can win a lot more money than if you take one option, and you’ll lose a lot less money than if you take one option and lose straight. It’s a good tool to have in your trading toolbox.
Example of a Binary Hedge
The scenario is based on a forex binary option on the Euro’s price. In this case, the Euro has been climbing and is expected to continue to rise until it reaches a defined breakout point. At this point, you would take a bet on the Euro continuing to rise. But what if the price suddenly reverses and falls? You can place a put option at a different point to help you reduce risk if the price does indeed retrace.
You have placed a call for $500 at the option price of 5.1 in the example above. You’ve also bought a $500 put at the 5.3 option price. The following results are possible:
- Your call option may expire at exactly 5.1, making it at-the-money. Your initial investment would be returned to you in the amount of $500. In this situation, your put option would be in-the-money, and you would collect $850 for your initial investment. The total investment is $1000. The profit is $350. This trade would make profit.
- Both your put and call options might be in the money if the Euro price expires between 5.1 and 5.3. For both trades, you’d be paid $850. The total investment is $1000. There is a profit of $700. This trade would make profit.
- Your call option may expire out-of-the-money if the Euro price falls below 5.1. Your initial investment would be returned to you in the amount of $75. In this situation, your put option would be in-the-money, and you would collect $850 for your initial investment. The total investment is $1000. There is a profit of -$75. Although this deal will result in a net loss, you will still lose far less than you gain in other cases.
- If the Euro price rises over 5.3, your call option will be at-the-money, and you will be paid $850 for your initial investment. Your put option would be out-of-the-money in this situation, and you would receive $75 for your original investment. A total of $1000 was invested. -$75 profit. Although this deal will result in a net loss, you will still lose far less than you gain in other cases.
- Your put option could be at-the-money if the Euro price expires at exactly 5.3. Your initial investment would be returned to you in the amount of $500. In this situation, your put option would be in-the-money, and you would collect $850 for your initial investment. The total investment is $1000. The profit is $350.
Conclusion
In each situation, hedging, or placing two bets in different directions, has the potential to yield a higher return than an all-or-nothing outcome of a single binary bet. In the cases where you stand to lose money, you lose far less than the chance you have to make a larger profit than the loss in other situations.
