Hedging Binary Options Strategy

A method of trading that’s widely used among expert traders, but is not well understood by most traders, is using one trade as a hedge against another. In this lesson, we will cover hedging in a very simple form and how to apply a hedging strategy in your trading.

Hedging and Asset Classes

Hedging is typically used in currency trading, but can also be applied to other asset classes. The basic concept behind hedging is to minimize risk or loss. You can hedge against a trade whether its trending towards an in-the-money outcome, or an out-of-the-money outcome.

Call Option and Put Option

In this lesson, we will use the terms call option and put option. The term call option refers to a trade that is believed to close at a higher price than the current price of the asset at the beginning period of the trade. The term put option refers to a trade that is believed to close at a lower price than the current price of the asset at the beginning period of the trade.

An example of hedging:

A call option is made on an asset with an expiry time set for 30 minutes after the trade starts. You carefully watch how the asset is doing 15 minutes into the trade.

If the asset moves into an in-the-money position, you have two simple choices you can make. You can ‘stay’ in your current position and wait till time expires. By doing so, the trade can either finish in-the-money or out-of-the-money if the price suddenly drops and you will lose 85% of your investment.

Let’s say the assets price is moving up and it looks like it will close above the opening price. Currently, that puts you in-the-money, however you still have 5 minutes before the trade expires. To hedge against this trade, you would execute another trade on the same asset, but choosing an option with a closing price that’s moving in the opposite direction of the initial trade.  If the initial trade was a call options, then your second trade would be a put option.

•    At the close of the trade, the price moved higher than the opening price. If your second trade was a put option the results of both trades would be: On your call option, you would be in-the-money, and on your put option, you would be out-of-the-money. Your out-of-the-money loss, plus your percentage payout would equal a total loss of 5% on your combined investment, making your total loss significantly less than the loss you would incur if you didn’t hedge against your trade. 

•    At the close of the trade the price closes lower than the opening price. If your second trade was a call option the results of both trades would be: On your put option, you would be in-the-money, and on your call option, you would be out-of-the-money. Similar to the example above, your out-of-the-money loss, plus your percentage payout would equal a total loss of 5% on your combined investment. Your typical hedging trade would come into play when an initial trade that looks promising, all of a sudden does a reversal so you hedge against the trade to minimize your loss resulting in a 5% loss as oppose to an 85% loss.

•    If the asset closes higher than when the call option was made, but closes lower than when the put option was made, both of your trades will finish in-the-money. You would receive the payout percentage on both trades. Even though you hedged against your trade because of a possible reversal you thought would happen, the result ended up being in your favor, and the reward that follows can quite lucrative.

This shows that even a hedge option which normally is used to minimize risk can result as a win along with your original option. This example only occurs when a circumstance arises, making you believe there will be a reversal in the price, and causing you to hedge against your original trade. If you’re certain the original option will close in-the-money, you may not choose to hedge against it. Hedging should be considered when there’s volatility in the market. Volatility in the market creates a greater chance for the price to change direction. Hedging a trade would be the difference of a 5% loss as oppose to an 85% loss for an out-of-the-money trade.

The Bottom Line

Hedging is a good strategy if used correctly. Ideally, you would want to apply a hedging strategy to call or put options, but they can also be applied to touch or no touch options as well. Use hedging wisely and you will reduce losses, and increase wins.