Hedging with Binary Options
Posted On May 3, 2020
For a currency day trader, not only do binary options give you the opportunity to make a great deal of money with a small move in the market, but they also give a trader an instrument to hedge currency positions.
The concept of hedging is the act of reducing the amount of risk that you currently have on your books. For example, if you had a long call position, you could reduce your delta risk by shorting the same underlying asset. Traders hedge their positions when the risks are not in their favor, or when a piece of news is about to come out and the information will create some uncertainty which might create volatility within the market.
So how can a trader use the binary options market to hedge some underlying risk? Let’s say a Euro currency trader wanted to hedge his long exposure to the EUR/USD right before the European Central Bank announce their interest rate decision. The trader could purchase a below option for the period overlapping the central bank announcement with an amount that would allow him to make a percentage of the notional value of the EUR/USD position that is held. If the announcement contained some information that caused the market to fall for a few hours (over even longer), the trader would be protected. The trader would incur some unrealized losses on his EUR/USD outright position, but would make back a percentage of those losses with gains in the below binary option. Many binary options trading payouts are 70% of the initial investment; this should be incorporated into any hedge calculation.
One way to calculate your hedge is to determine to how much you could lose give a specific event or release. For example, in looking at the example of the EUR/USD above, let’s assume the trader had a long position of 1 million EUR/USD, when the price of the currency pair was trading at 1.35. If a trader wanted to protect against a 2 big figure move (1.33), which is approximately a 1.5% loss. To hedge this exposure, a trader could purchase a below option that is worth 22 thousand dollars. If the market moved lower, the loss on the position would be approximately 15,000 dollars and the gain on the binary position (70% of 22 thousand) is 15.4 thousand dollars.
There are numerous additional binary options that can be used to create a hedge portfolio. A hit or miss option can be use to specifically protect both long and short positions. A miss option can even act like a covered call. Again when looking at the long EUR/USD position, a trader could purchase a miss option above the market. If the market rises, the losses on the miss option would be offset by the long EUR/USD position. If the mark falls, the gains on the miss option offset the losses on the underlying currency position.
Hedging is an important part of prudent trading and currency traders should look into binary options as a way to mitigate their exposure.