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;

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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.

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.

Binary Options Hedging Strategy

Using strategies in the dynamic world of Binary Options is a must. With so many different kinds of strategies out there, it becomes only a matter of personal choice when it comes to choosing the one to use in order to ensure great profits or limit fatal losses.

Some of the strategies are directed more towards the professional, experienced traders while others target the newbies, giving them a chance to put a simple method to a great use.

A good example of these newbie-oriented strategies is the Binary Options Hedging Strategy. It is one of the most popular ones in the binary options community; one with a range of everyday users relying on it; users who vary from inexperienced to advanced traders.

That leads us to the most important question to answer:

What exactly is the Binary Options Hedging Strategy?

Before putting it in a binary options-context, we must first look into the meaning of the hedging itself. In simple words, hedging means mitigating, controlling or limiting risks. A real-life hedging is, for instance, buying insurance for your house that will act as a hedge against weather disasters or thieves.

The similar concept applies in the options trading market, too. With the Binary Options Hedging Strategy, you are to execute both put and call options on the same asset, at the same time. This is mostly used in volatile markets, sensitive to the surrounding and easily affected by the accompanying events.

The idea is to cover both possible outcomes simultaneously in order to prevent losing all of the funds invested. This way or the other, upon expiring, there would be profit from one of the trades and you are guaranteed a moderate gain or, in the worst case scenario, as less a loss as possible. So, basically, in the binary world, the Binary Options Hedging Strategy is your insurance against bankruptcy.

So, where can this strategy be applied?

The number of ways in which this particular strategy can be used is almost unlimited: from commodities to currency; pretty much everything on the market can be hedged. In fact, currency as one of the most heavily traded assets, subjects to hedging on a day-to-day basis. Currency pairs such as EUR/USD fluctuate a lot which lays the ground for the perfect hedging scenario.

Whichever you choose to focus the Binary Options Hedging Strategy at, one thing remains crucial: market observation is a thing you cannot proceed without. Follow the news, keep in mind all the things that can affect the price of the asset you are trading, read the charts carefully, analyze the statistics and always, always make informed decisions only!

Ensuring profit with as little risk as possible is the ultimate goal for each trader and as we mentioned above, there are different methods and techniques in order to achieve that. Ranging from ones that are simple and easy to use to the more complex and difficult to comprehend, these techniques, combined with a thorough market analysis, can be a life-saver when it comes to trading binary options.

Still, not everything is rainbows and butterflies. That is why the most important piece of advice regarding these strategies is to approach them and use them with caution, using only the ones you are confident in! Remember, the best strategy is always the one you excel at!

DISCLAIMER: Futures, stocks and options trading involves substantial risk of loss and is not suitable for every investor. The valuation of futures, stocks and options may fluctuate, and, as a result, clients may lose more than their original investment. The impact of seasonal and geopolitical events is already factored into market prices. The highly leveraged nature of futures trading means that small market movements will have a great impact on your trading account and this can work against you, leading to large losses or can work for you, leading to large gains.

If the market moves against you, you may sustain a total loss greater than the amount you deposited into your account. You are responsible for all the risks and financial resources you use and for the chosen trading system. You should not engage in trading unless you fully understand the nature of the transactions you are entering into and the extent of your exposure to loss. If you do not fully understand these risks you must seek independent advice from your financial advisor.

Easy How To: Use Hedging With Binary Options

Many subtle aspects of Binary Options often go unnoticed by Binary Option traders. The most interesting perhaps is that there are many ways to trade Binary Options in a manner that reduces risk. One of these is hedging.

The principle is simple: Strengthen your position if you are right and hedge it if you are wrong. Let’s see how this works. In the images below, the GBP/JPY succeeds in a breakout in CASE A and fails the breakout in CASE B. Using your Binary Options trading account, at www.StartOptions.com for example, you would place a CALL Binary Option trade at the moment of the breakout in both CASE A and CASE B. In CASE A the breakout succeeds and you reap an 85% profit, say $85 if your trade stake was $100. However in CASE B the breakout fails. At this point you have 2 choices: lose $100 or hedge your trade. If you choose to hedge your bet by placing a PUT Binary Option trade when the breakout fails, the trades now cancel each other out resulting in a $15 loss instead of a $100 loss(win $85 – lose $100 = $15).

So let’s assume that 50% of breakouts succeed, in a pessimistic world. Under this assumption you will win $85 (50% of the time) and lose $15 (50% of the time) which makes a steady income of $70.

One interesting comment on Binary Options hedging: don’t try this with your conventional Forex account…conventional Forex accounts don’t allow you to hedge on the same instrument…if you try it you will find yourself selling off you own position!

Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Open Markets involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of FXStreet nor its advertisers.

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