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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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Hedging Your Binary Options Trades
When it comes to a Binary Options trading making many more profitable trades it is often through hedging that this is achieved. Hedging is simply the name given to when a trader places more than one single trade on any company’s share value, commodity or any type of trading opportunity.
Initially a trader will place a trade on their chosen opportunity, however if that trade as it is live is looking more and more likely that is will not be a winning one then that trader will place additional trades on the same option but in the opposite way as the original.
So for example is a trader has a live trade on let’s say the value of oil dropping, however as that trade is live the price of oil is rising he or she will then place another trade whilst that one is live on the price of oil rising over a set time period.
However, one of the ways they will often be funding those hedged trades is by using one of the bonuses that they may have claimed by signing up as a new trader at a Binary Options Broker. By using this type of hedging strategy they are going to end one of their trades in profit having covered both sides of the trade.
In fact as many Brokers occasionally offer their traders a range of no risk trading opportunities should you get one offer at two different Brokers then you can place a trade on both sides of that trade with the no risk trade and one of them will be in profits at expiry time and the one that isn’t will see you getting your invested funds on that trade back from the Broker by virtue of the no risk trade!
Frequently Asked Questions
- How Long Will It Take to Learn How To Hedge?
Do not think that you are going to be able to master the very fine art of hedging Binary Options trades instantly, as it can take a lot of practise and determination in regards to tracking down the very best and ultimate hedging opportunities.
You are going to be best off placing a range of initial trades via a demo trading account whilst you are learning the art of hedging, as you will be doing so in a no risk trading environment, so any initial mistakes you do make will not be costing you anything.
Can I Hedge Any Type of Trade?
It doesn’t matter what type of Binary Option trade you are looking to hedge you are going to find plenty of hedging opportunities are available on any type of trade.
Just remember that the way in which you are going to often get the best value is by you making sure that the price you are being quote and you take for placing a winning trade should be the very best ones on offer, so do shop around to get the best prices possible!
Are Commodities Suitable for Hedging?
With there being so many different commodities that you can base your Binary Options trades around you may be under the impression those will be the best and most ideals ones to use for when you start hedging your trades, but you may find them perfect for your very first initial hedging trades.
However, never restrict the range or type of trades you can place by sticking to just Commodities as you will find you can hedge any type of Binary Options trading opportunity and as such you are as likely to have just as much success for example when you hedge company share values and other stocks and shares as you will do by hedging Commodities.
Can US Traders Hedge Trades Easily?
One question that you may be looking for the answer to if you are one of our US based website visitors is whether you are going to find enough Binary Options Brokers to allow you to have plenty of platforms available to hedge your trades.
Well fortunately we have quite a number of fully licensed and approved US facing and US trader friendly Binary Options Brokers listed on our website and as such you should have no problems finding several of them at which you can open and account and then start to hedge your trades quickly and easily.
Binary Options Hedging Strategy with a High Success Rate
Looking forward to using binary options hedging strategy with high a success rate?
This article is meant to you as we are going to uncover the technique that can materialize this goal.
In this article, you will be prompted with a step by step process of understanding the important things about hedging binary options.
Of course, tons of information can be gathered from the Internet but not all of them are going to point out the right way.
Some information is just nuance, while others are purely misleading.
So, today let’s undo the surrounding factors to hedge the binary options with a high success rate.
One thing to keep in mind, hedging is a procedure that both novice and experienced traders must use.
Before you read the rest of this article, I suggest you to read this article carefully: Trading Strategies Don’t Work If You Don’t Choose the Right Living Strategy
The Main Reason Why Novice and Experienced Trader Must Use Hedging
Even you are an experienced trader, you will always need hedging strategy because not everything in the market is within your control.
Unless you are a gambler, hedging will have no use at all.
But if you want to make profits, and increase them, then you must use hedging to succeed in these goals.
Hedging is a money management with the main target––to offset losses so that you can protect and gain profits.
By implication, it will make you get ahead of the game in the market share.
Regardless of what you did just to put your investment safe and secure, the fact remains that there will be a surprise price movement that can crash the stock price in the market.
Such is a common pitfall that creates the trading’s image as a risky venture.
This weird incident can be mitigated through hedging.
The main procedure of hedging is to go long on a particular asset and short on the competing asset with different directions.
And if you have the ability to identify short-term market trends, you are most likely to become effective in protecting your investment.
Hedging is used in different areas of investment but let’s focus on the binary options trading.
As the term infers “binary”, we will be dealing here the two commands that require hedging.
The Two Commands to Hedge in Binary Options Trading
There are two commands in the binary options trading, the call, and put options.
The call option is the rights to buy but without an obligation to do so, if you are the buyer.
Whereas, if you are the seller of this type of option, you are expected to sell the asset if the buyer is willing to exercise his right to purchase it on or before the expiration date at a specific price (strike price).
On the other hand, the put option is the rights to sell a chosen asset but without an obligation to do so, at a specified price, in a predetermined date.
Before embarking on hedging these two commands, there are few things you need to do.
First, have a risk tolerance to objectively face and handle all potential risks.
Second, secure right tools and resources for monitoring the surrounding factors of trading.
To start hedging, you have to identify a particular percentage of the position you want to hedge.
You can accomplish it by multiplying the option cost with the percentage you want to hedge.
Then, mitigate the two possible risks associated with the options, delta and vega risks.
Handling the Delta Risk
Delta refers to the changes in the option’s value when the price changes in the underlying security.
The delta risk becomes imminent when volatility goes higher which implies, the higher the volatility, the riskier the security.
To hedge, you have to make a short sale of the underlying stock or sale of an option that will offset the delta risk.
The shortening of the stock has to be equal to the delta at a specific price.
For instance, if 1 call option of XYZ stock has a delta of 50 percent, then you will hedge the delta exposure by shortening 50 shares of XYZ.
Or, buy a put option which has a negative delta.
You may also sell the call option with a different strike price.
Handling the Vega Risk
The vega of an option occurs when it is exposed to implied volatility.
Implied volatility is about the expectation of the market of the price movement.
It relates to the reaction of the option’s price to every 1% change in the volatility.
For example, if the call option has 0.5 vega, its price will peak $0.50, but if the volatility falls 1%, the price drops $0.50.
Implied volatility creates a theoretical value of the underlying asset.
To hedge the vega risk, you have to sell or buy another option that can mitigate the risk.
You may try buying spreads such as the bull call spread as this can limit the volatility risk in the trade.
With bull call spread, you can buy a number of calls with the same strike price and sell them at the higher strike price.
The Main Technique for a Successful Binary Options Hedging
Obviously, a strategy is distinctive from the technique.
A strategy is a creative way of achieving the purpose.
However, if it is coupled with one or more techniques, it will have more success rate than you can normally expect.
You can try any available hedging strategies out there but one thing for sure, this technique surely boosts the outcome.
We call this technique as “identifying the known unknown factors”.
These refer to events of which you have basic knowledge but you are not sure about the results when they take place.
Apparently, not all professional traders will likely share to you this technique.
Therefore, you are on the edge of knowing it as early as now if you are a novice.
As you must know, volatility plays a huge impact on the success or losses of your investment.
This is where the known unknown factors surround and make an impact upon.
Volatility is a degree of price fluctuations as the immediate result of the supply and demand in the market.
The higher the volatility, the riskier it is to make an investment.
Therefore, get your hands on these few known unknown factors.
The Few Known Unknown Factors that Influence Volatility in the Market
1) The Earnings Reports
The earnings report is one of the things you have to look into prior to making the investment. Below are the key points that usually take place
- There will be large price swings in either direction after the earnings reports have been announced.
- There is a huge possibility of the volatility to peak up one week prior to earnings which spike before the announcement.The most observable behavior of volatility is ranging from three to four times the normal levels.
- Volatility tends to fall down sharply right after the announcement.
2) The Economic reports
This has also a huge impact on the price movement in the market.
So, be aware of the possibilities associated with the economic reports such as the following:
- The price swings take place right after the announcement should economic report misses consensus estimates.
- The price movement’s direction gets unpredictable and it will make not be wise to do investment during this period.
- Volatility mellows down right before the major announcements.
- Volatility increases at a fast rate after the announcement, unless the report is close to consensus estimates.
3) The Monetary Policy Decisions
The volatility is influenced also by monetary policy decisions.
Therefore, cleverly spot the tendencies of volatility to ensure an effective hedging.
- There will be price swings in the equity right after the announcement if the report differs from expectations.The moves are usually greater during unexpected announcements or scheduled meetings.
- Volatility is modestly lower prior to big announcements, unless unscheduled.
- The spike of volatility takes place following the unscheduled or unexpected announcements.
Binary Options Hedging Strategy Together with the Main Technique for a High Success Rate
1) The Straddle
Having laid the technique for successful hedging, let us combine it with commonly practiced hedging strategy, called straddle.
In this strategy, you are going to hold a position in both a call and put options with the same strike price and expiration dates.
A straddle is favorable when you are not sure about the direction of the asset’s price movement if it will go up or down.
Just one thing to keep in mind, make a small and reasonable amount when there is less price movement in the market.
To use straddle, you have to make two bets (call and put options) on the same asset.
However, binary options trading brokers do not allow placing a call and put options on the same asset in this current market trends.
To resolve this, you can do these alternative ways as follows:
- Make varied expiration on call and put options using the market indicators.
- Increase your investment in the most favorable option to expand your in-the-money (ITM) potentials.
- Use the same trade bet with the same expiration, but this is not actually the best way to use straddle
2) The Two Requirements
- Both of the call and put options must have the same strike price.
- The market should be in the state of volatility to have a clear path towards making profits.
A stable market is less likely to render price difference, which means, less opportunity to make profits.
In this regard, a realized volatility must be higher than implied volatility.
Otherwise, your investments will be prompted with huge risks.
The realized volatility is simply understood as actual daily price movement of an asset, while implied volatility is inferred as what the market is expecting.
3) The Profit Calculation
1)When underlying asset’s price increases
Profit (up)= price of the underlying asset-the strike price of the call option -the net premium paid
2) When the underlying asset’s price decreases
Profit(down) = strike price of the put option-underlying asset’s price-net premium paid
The maximum loss incurred with straddle is when the price of the underlying assets is equal to the strike price of the options at expiration.
In addition, be aware that there are two breakeven points in a straddle position.
- The upper breakeven point which is equal to the strike price of the call option plus the net premium paid.
- A lower breakeven point which is equal to the strike price of the put option less the premium paid.
4) The Profitable Straddle Position
The long straddle position.
This position gives unlimited profits and less risk.
Whether the price increases or declines, you are assured of profit-making in some degree.
This is materialized by purchasing the long call option and put option with the same strike price and expiration.
The strike price is a fixed price which you can either buy or sell an underlying security.
In order to benefit from its so-called unlimited profits, learn these two important considerations:
- Find out in the market that is in a tight range and can reflect a huge and sustained price movement.
- Check for what is at the lower end for a considerable time, can be six months or a year, with implied volatility ranges.An increase in implied volatility takes place when prices of calls, puts and straddles frequently rise prior to earning reports and announcements.
To achieve breakeven points (strike price plus or minus the net debit), the underlying security price must increase or decrease farther than the strike price whichever the direction moves.
The profit becomes maximum only on the upward skew of the price movement while substantial on the downsides.
In essence, this strategy is a race between time decay and volatility.
Time decay erodes the position’s value as the time draws near to the expiration.
On the other hand, volatility is about the fluctuation of the trading price over a period of time.
The Three Types of Straddle
1) The Strips
It is a modified version of the common straddle but more bearish in essence.
It is considered as the neutral options trading strategy because of unlimited profit potential on the upward price direction of the underlying asset, unlike during downward price movement.
Here, you’ve got to purchase 3 options, one ATM call and two ATM puts with same strike price and expiration date.
The risk or potential loss is the total option premium paid (plus brokerage & commission).
2) The Strap
It is alternatively called “triple option” of which you buy one long put and two call options with the same strike price, maturity, and underlying asset.
This is favorable if you believe that the future price movement of the underlying asset will be large and more in upward skew.
However, in the event that there is potentially large price reversal, you can sell the put option prior to the expiration date and stay with the call options to make profits.
3) The Strangles
It is analogous to a straddle, holding the position in both calls and put options with same expiration date and underlying asset.
However, the strike prices are different.
Your chance to make profits in this strategy is when there is large price movement of the underlying asset.
Strangles is not expensive because the options are bought out of out-of-the-money (OTM).
There is low risk and to achieve this, you have to sell the lower strike price and purchase the upper strike price.
Strangle is quite effective if you do this in relation to the upcoming news report.
The Odds of Using Straddle and Ways to Handle Them Effectively
Straddle can make you so much money if done correctly.
The upside is unlimited.
But if you are an uninformed investor, you tend to get swayed by what it looks like at the surface–its simplicity.
In the reality, it is not the real story.
You will lose lots of trading money if you failed to know how to use it.
Much of the literature about straddle is mixed up with conflicting information.
There is one side which tells you to use it while the other warns you to avoid it.
Well here are the facts about straddle and how to go about them to profit in trading.
Odd #1) You can potentially lose huge money.
This is an expensive strategy.
Its cost is the common cause why investors lost huge money.
In order to regain the loss, it would require huge movement of the price in the market but you can’t expect higher than 20% price movement.
It is almost impossible to take place.
How to really benefit from price movement? As mentioned above, you have to be aware of the events “the known and unknowns”.
You should know the exact dates of the events.
But note the difference between the potential date and exact date of the events.
In the straddle, you have to be surety with the exact date the event is going to happen.
It is a common practice with straddle to trade using volatile stocks, you can barely assure yourself with it because they are unpredictable.
So, what are you going to do instead?
Pick an event that will most likely affect the price movement such as quarterly earnings.
The perfect candidate is the new release or launched products.
These have a vague number of products sold within the quarter period.
Odd #2) It can cost you lots of money.
Trading on expensive stocks will cost straddle much for you.
For example, there’s a 10% price movement of the stock in the market.
If the stock price is $40, you will spend a total of $8 for the two opposing directions with $4 each.
But what if the stock price costs $400?
This will be too costly per straddle.
Keep your investment always at low when you use straddle.
Odd #3) It needs right timing to buy the stock.
While it is a must to avoid expensive stocks, be aware that there are different variables can come into play as well.
However, using the past performance of the stock after the earnings report is the best way to start making the decision.
Also, do not overlook the type of the stock.
In most cases, professional investors are looking forward to the last two weeks before the event.
This is to avoid buying the stock at the peak demand.
While you may think of buying too early, it won’t be ideal at all.
Two weeks or 14-21 days before the event is a pretty good thing to do it.
Several Hedging Strategies
In binary options trading, you can use several hedging strategies.
However, the Straddle is proven to protect your investment, if done appropriately.
Learn that beyond its simplicity on the surface level there is great potential loss ahead of you.
So be aware of the specific technique to finally achieve a high success rate.
Also, make sure that you have sufficient background knowledge about its pros and cons as disclosed above.
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Rosalie Tayurang is a Psychology graduate with various work experiences online and off the net. Curious and cautious, she believes learning should be kept growing. View all posts by Rosalie Tayurang
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