Binary Options Hedging

Looking to understand more about binary options hedging? This guide will cover how binary options trading works, the best hedging strategies, plus the pros and cons of this technique. We’ve also listed the top brokers that support binary options hedging.

The Best Brokers For Hedging

Binary Options Explained

Binary options contracts typically offer a fixed profit if the value of an underlying asset hits a specified price at a certain time (usually short-term). They vary from other financial instruments because there aren’t usually additional gains if the price soars.

Let’s say a trader buys an AAPL binary options contract which pays out $100 if APPL passes $500 at 2 p.m. the next day.

Each binary option is made up of 100 contracts which cost a premium of $0.20 each.

Therefore, it will cost the trader $20 to buy the option. There are only two potential outcomes: APPL will pass the $500 price point, or it won’t.

• If APPL passes $500 at 2 p.m. the next day, the trader receives $80 in profit ($100 payout less $20 premium)
• If APPL doesn’t pass $500 at 2 p.m. the next day, the trader loses $20 ($0 payout less $20 premium)

How Binary Options Hedging Works

Binary options hedging is when investors use binary contracts to mitigate potential losses. They can be used to hedge various asset classes, from stocks and forex to commodities and cryptocurrencies. They can also be used to hedge other binary options positions.

Let’s look at an example: we know the price of an underlying asset has been fluctuating between $12 and $15. Therefore, a trader can buy two contracts to cover the potential outcomes:

• A trader buys 100 binary call options with a strike price of $15, and each contract costs $30 with a payout of $50
• The trader also buys 100 binary put options with a strike price of $12, and each contract costs $30 with a payout of $50

The table below highlights the potential results.

By entering conflicting positions, the initial investments in both binary options are partially covered, reducing potential losses.

But whilst this strategy may work in theory, it’s not always straightforward to execute in real-time trading conditions. Some brokers also prohibit binary options hedging. As a result, traders may need to split their portfolio across several trading platforms.

Binary Options Hedging Strategies

Hedging with binary options contracts can be used to offset losses across various markets:

Stocks

Hedging stocks with binary options can be effective. Binary contracts can be used on both long and short positions. Whether the trader goes long or short will change the position of the hedge, which we’ll explain below.

But first, let’s look at what could happen if you were to hedge stocks without binary options.

Hedging Stocks

A trader believes BP is undervalued. So, they buy 1,000 BP shares at $20 per share at an initial investment of $20,000. If the price hits $50, the trader will sell. They also set a stop-loss of $12 per share to automatically exit their position if the market moves against them.

In this scenario, the maximum potential gain is $30,000 ($50,000 profit less $20,000 investment). The maximum potential loss is $8,000 ($20,000 investment less $12,000 stop-loss value).

Now while the potential gain is large, the risk of loss is also significant. Let’s see how binary options

could reduce the risk exposure…

Hedging Stocks With Binary Options

Since the trader has a long position, they will realize gains if the price goes up and experience losses if the price drops below the original investment price per share ($20).

However, a binary put option could pay out if the price falls below a certain value, therefore, hedging the position.

Using the same example as above, the trader is offered a $20 BP binary put option with a payout of $200 if the price falls to or below $12. If this happens, the profit per binary options contract will be $180 ($200 profit less $20 premium).

The trader decides to hedge the $8,000 risk with 40 binary options ($8,000 potential loss/$200 profit per option). The position is now hedged but costs the trader an additional $800 (40 binary options x $20 premium).

The table below highlights the potential results.

Binary option pay-out (40 options at $200 profit)$8,000$0$0

With the inclusion of 40 binary options at $20, the initial investment has increased to $20,800.

However, the hedge and the stop-loss at $12 have decreased the maximum loss from $8,000 to $800. This hedging strategy has successfully reduced the size of the loss and has only slightly reduced the potential profit if the price of the stock rises.

For hedging a short position, the process is the same, but the trader is hedging against the price of the stock increasing.

Forex

Binary options are offered on most major and minor currency pairs. The strategy for hedging forex with binary options is very similar to stock hedging.

If a trader is long on a currency pair such as GBP/USD and the price of GBP begins to fall, the trader could buy a binary put option to mitigate potential losses.

Similarly, if a trader is expecting the price of GBP to fall versus USD, then the trader could enter a short position and buy a binary call option to hedge the trade against the price of the currency increasing.

Cryptos

The process for hedging digital currency is the same as the other asset classes mentioned.

However, since cryptos are volatile by nature, there are slightly different challenges and opportunities.

The price of coins can swing significantly in a single day, which could wipe out a trader’s position if stop-losses are hit.

Fortunately, traders can assess a cryptocurrency’s daily break and resistance lines and buy binary options at either the peak or trough.

With that said, cryptos come with an additional challenge because they are available to trade 24/7.

Therefore, traders must ensure that any binary options purchased will continue to hedge their position
overnight and on the weekends.

Pros Of Binary Options For Hedging

There are several advantages to hedging with binary options:

• Availability — Binary options are available on a range of markets and can be bought to cover both long and short positions
• Simplicity — Compared to other hedging techniques, binary options are straightforward to implement as the premiums and payouts are fixed at a known price
• Low Cost — Premiums on binary options are relatively cheap compared to the cost of owning the asset being hedged

Cons Of Binary Options For Hedging

There are also some drawbacks to hedging with binary options:

• Broker limitations — Some brokers restrict the use of binary options hedging techniques on their trading platforms. To avoid these, see our list of supporting brokers above
• Contract types — Traders may find it difficult to find binary options contracts which precisely match their needs, for example, the desired strike price and expiry
• Volume — Some binary options hedging strategies often require many different trades and positions to effectively mitigate losses

Final Thoughts

Binary options can be used to hedge a variety of asset classes and positions.

The risk management tool can also be employed by traders of all abilities as contracts are easy to understand with fixed expiries and payouts. Use our guide above to get started.

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