Hedging strategies in binary options trading are the phenomenon of exposing both call and put options on the same financial instrument to avoid huge losses due to unpredictable market changes. Sounds complex to understand? Stay with the article and consider the simplification. Here we will explain what hedging is and how you can make the most of it.
Most important facts:
- Hedging with binary options entails purchasing call and put options concurrently, aiming to diversify investment risk rather than significantly reduce it.
- Accurate market predictions may yield profits ranging from 60-80%, but incorrect ones could result in the loss of the entire stake; hedging seeks to balance potential losses.
- In hedging, traders acquire both types of options on the same asset, which could lead to gains if the market moves distinctly, but net profit is not guaranteed due to the cost of both options.
- Traders utilize support and resistance levels to inform their decisions on when to place call and put options as a hedge, with the goal of securing a profit, although market unpredictability can affect outcomes before the options expire.
What is the Binary Options hedging strategy?
As the name “hedging” implies, this strategy for binary options is about protecting your investment from a potential loss by opening a position opposite to your current one. Unlike other strategies that focus on maximizing profits by predicting price movements, hedging aims to mitigate potential losses.
It’s like taking out insurance on your trades; if one position fails, the other will profit, effectively offsetting the potential financial impact. The main reason traders use this strategy is to manage risk, especially in volatile markets where price movements can be unpredictable. By hedging a position, a trader can ensure that even if the market moves against his original trade, the loss can be offset by the profit from the hedged trade.
Why do you need hedging for Binary Options trading?
The concept of binary opinion trading is based on a single question: “Will the market end up going up or down from a certain price point within a certain time period?“. In short, it is about predicting the future profit or loss of the market at a given time.
If the result on binary options is correct according to your prediction, then you get a profit of 60% to 80% along with your invested money. On the other hand, if the market goes against your prediction, you lose 100% of your investment.
Let us understand this with an example to make things easy.
Suppose you are a trader and you trade binary options. You have been watching the price of petrol for the last month.
- After applying your strategies and reading the graph, your mind comes to the conclusion that next week the petrol market will go over $1500. So, keeping this in mind, you invest $100 with the expectation that the petrol market will be above $1500 next week.
- After a week you see that the petrol market has gone up to $1550, so your prediction is correct. Now you get a fixed amount of profit of 60%. So your $100 will turn into $160 when you get the profit.
To look at this situation in reverse, suppose the market has moved against your prediction. For example, you had predicted that the petrol market would go above $1500, but for some reason it goes down to $1400.
In such a situation, you lose all the money you put into the trade. So even if the market only moved 10%, you would lose 100% of your investment.
This loss is a huge burn! But what if, in these circumstances, you could find a technique that would allow you to match your odds?
That’s the point when you need ‘Hedging Strategies’ for your trades.
What is Binary Options hedging? The strategy explained
Hedging is a strategy that traders implement to avoid the risk of loss in investment. It’s like buying insurance for your investment to bring down the loss burnouts.
Let’s try to illustrate this with an example from our everyday life.
Whenever you buy a new car, you also buy insurance for that car. The idea is that if there is an accident with the car in the future, you can get a refund. In the same way, you invest your money in two places.
The same rule applies to hedging with binary options. Again, your money is invested in two places so that even if your prediction goes wrong for some reason, you can still recover the money you lost.
Now let’s dive into the exact strategies of hedging.
Binary Option hedging strategies
In simple words, you have to buy two binary options for the same instrument. One option for the call (raise of market price from initial value) and the other for put (down the market price from initial value).
#1 Using Put and Call together
For simplification, assume you are trading on Gold. Now, you buy two trades for Gold for $200 each. You can use one binary option for a call and the other for a put. So you have two predictions: if the market goes up, you will have profit, and if the market goes down, you will still make a profit.
Let’s assume that the gold market is currently trading at $1700, and if the prediction is correct, you will make an 80% profit.
Next week the gold market reaches $1800. When you have bought both the call and put binary options for $100, you will have $180 in profit. Overall you will have a $180 profit on the call and $100 in loss under the put. So you will get $180 – $100 = $80 profit.
By doing binary options trading in this way, you greatly reduce your chances of losing. The only problem here is that not every broker provides the facility of hedging on the instrument.
Make sure to pin the point that you can purchase a call as well as a put for the identical financial instrument on a similar strike cost, but they won’t be hedged. Hence, they will move in a reciprocal direction resulting in money loss by using binary options.
#2 Resistance and support
Now there are other ways of hedging that are based on the concepts of resistance and support.
Firstly, you need to find the range in which the price will move between a particular support and resistance. Then the aim is to open the call and put on the support and resistance. The idea is to hedge your position. If you hold a call at the support price, the price will rise until it reaches your resistance area. You can then sell a put.
This will lock in your profit from the call and put before the options expire. Between the support and resistance, there’s a 99% chance that the cost will close somewhere in the middle of the support and resistance.
When your binary options expire at this point, the price will be lower than your opening price and the amount will be higher than your call opening. So from here you have the first scenario where you can make a double profit with the potential for a guaranteed profit.
Now let’s consider the second scenario; by implementing the same plan, you have to buy a call and a put. However, the support is broken this time, and it is pretty obvious that the support does not hold forever (as explained in the the support and resistance strategy).
This time the support will be broken close to the expiration date, so your call investment will suffer a loss, but at the same time your put investment will gain. So once again you have a guaranteed profit, but with a reduced loss. Whatever the situation, your profit is guaranteed on at least one position.
- → So your loss will be dramatically reduced. However, if you place a call to the support line, you will incur a loss.
Let’s say you placed a $10 call at the lower expiry price. You will now make a loss of $10. If you hedge that point with a $10 put, you will have a $10 loss on your call.
Instead, you could make a profit. Assuming the payout is 70%, you will lose $10 on the call, but at the same time you will make $7 on your put. This way you only lose $3 instead of the 100% amount, which is $10. So let’s move on to the first scenario; you can make a double profit by hedging the position.
Understanding the mechanism of hedging
So there are different ways to approach hedging strategies in binary options. However, hedging is not limited to binary options. The concept of hedging goes much deeper. Advanced investors use the concept of hedging in many financial areas. There is no need to get lost in the complexities of hedging strategies, but knowing the core mechanism is crucial.
Example 1: Hedging with ABC Company Shares
Let us take an example to understand this better. Suppose you are an investor and you want to buy shares in a company called ABC. Now the price of a binary call on this company is around $20. Therefore, to buy one share of that company, you would have to pay $10.
In the hedging strategy, you buy a binary call and a binary put option. As mentioned above, the binary call price is $20 and one share of ABC company costs $10. Therefore, the total value of the binary call is equal to one share of the company.
Now we see that the strike price of company ABC is the same as the binary put, which is $10. So, in simple terms, as an investor you make money immediately.
This is because you bought the binary option at the time when the exercise cost of the elemental options was lower than the cost of the hedged options.
You have already been told in this article that whenever you buy a binary option, you own the right to buy a financial instrument at a specific price.
Example 2: Hedging with DEF Company Shares
Similarly, if you look at another option, suppose you are an investor and you want to buy shares in a company called DEF. Again, the price of 1 share of this company is $10. So if you buy a Binary Call at the strike price of $10, you can again make a profit of $10.
Although the binary put strike price is $20, the old strategy will not work this time. As an investor, you can make a profit on a put if the cost of that financial instrument goes down. Now, the strike price is higher than the cost of the instrument when the option expires.
So you buy a binary put with a strike price of $10. When the binary put expires, you have the right to buy one share of DEF for $10. If you sell a binary put whose strike price is $10 and the price of 1 share of the company is also $10.
This means that one share of the company is worth exactly the same as the strike price of the put. So now you have the right to sell the shares of the company, you will make a profit as an investor if the cost of the shares of the company DEF is greater than $10 at the time the binary put expires.
In this example, remember that you initially bought the put at a strike price of $10. If the investor then wants to fence the put with a strike price of $10, you want to buy the call with a strike cost of $10.
Advantages of Binary Options hedging
#1 Hedging is a low-risk game
The fact of placing multiple trades for a particular asset makes it a lower risk game. When you place both, call and put (opposite bets) for any option, they don’t lose 100% of the amount. However, the profit is less but it never tends to 0.
#2 Offers better trading conditions
Hedging is an easy game, but only if you are a pro or someone with experience. For the one who has just entered binary options trading, you should know that scamming is quite frequent in the field. Therefore, finding a genuine site is the first and most vital step in trading.
#3 Pro tip for Binary Option trading
If you have noticed the price graph at the lower side for at least half a year or one year- it’s a symbol of stable price growth. Instead, if you notice frequent downfall of the price, that’s the best time to invest. However, if you notice an increase in price for a long time, it’s simple for you to predict price movement.
Conclusion – Use hedging strategies to trade successfully
In summary, hedging in binary options trading is not just a tactic, but a critical approach for managing financial risks and enhancing profit potential. By employing the right hedging strategies, you can navigate the volatile landscape of binary options with greater confidence and control. It will help you to balance your positions, safeguarding against unpredictable market movements. As a result, hedging becomes an indispensable part of your toolkit, offeringyou a pathway to more stable and predictable financial outcomes. Understanding and applying these strategies is key to achieving success in binary options trading.
Frequently asked questions (FAQ) about the hedging strategy:
What is the primary purpose of hedging in financial trading?
The primary purpose of hedging in financial trading is to secure consistent profits and reduce the risk of substantial losses.
How does hedging benefit binary options trading?
Hedging benefits binary options trading by providing a strategy to manage financial risks and potentially increase profit margins.
Can hedging strategies guarantee a win in binary options trading?
While hedging strategies can significantly improve the chances of profit, they do not guarantee a win due to the inherent risks and unpredictability of financial markets.
Is it essential for traders to understand hedging strategies?
Yes, it is essential for traders to understand and apply hedging strategies to navigate the complexities of binary options trading effectively.