Binary Options Hedging Strategy: Explained

Unlike DJ Khalid, it is not possible for retail traders to always win, win, win, no matter what.

That’s mainly because most of us do not live in a rap music video—and because trading and investing are inherently risky. However, while taking on risk is inevitable, it is possible to mitigate such risk using financial derivatives like options and futures as a hedge. 

Hedging is a widespread strategy used by traders today. In 2020, 46.77 billion contracts were traded worldwide, up 35.6% from 2019. ✅

This article will be looking at an exotic type of option called binary options and how you can use them to hedge against various asset classes. We’re also going to examine how hedging works in general and the drawbacks of using binary options.

How Can Binary Options Be Used for Hedging? 🤔

Trading binary options is a bit like playing Russian roulette—you either lose everything or make $100. That analogy might not have been perfect, but many believe that binary options can help perfect your trading strategy and mitigate your trading risk.

How Do Binary Options Work? 💡

Binary options are not very popular here in the USA. In fact, there aren’t too many brokers in the USA that facilitate binary options trading, but the popularity seems to be growing after they were approved by the SEC In 2008. So, before we go deeper into this article, let’s take a quick overview of what binary options actually are:

A binary options contract is a financial instrument that offers a fixed profit (usually $100 in the USA) or becomes worthless (the trader loses the premium paid). The outcome is based on the price of an underlying asset like a stock, index, currency, or commodity.

Like Batman’s Two-Face, a binary option only perceives the world from two opposite perspectives. One that makes you a profit (expiring in the money) or one that burns you (expiring out of money).

Expiration Date and Time ⏱️

Just like regular options, binary options contracts have an expiration date/time. Once the expiry arrives, the option will be settled, and the trader will make a profit or loss.

A predetermined strike price decides if the option pays out or becomes worthless. Some binary options can be cashed out before the expiry date too. At the same time, some types like one-touch binary options can also instantly pay once the strike price is crossed.

There are several types of binary options that work slightly differently. Some of the popular types of binary options include:

• ☑️ High/Low
• ☑️ One Touch/No Touch
• ☑️ Boundary/Range
• ☑️ 60 Seconds/Short Term
• ☑️ Long Term
• ☑️ Ladder
• ☑️ Pairs

Here’s an example of a straightforward binary option—if TSLA goes above $950 (strike price) on 10th July (Nikola Tesla’s birthday/expiry date) next year, the option will pay $100. The option is priced at $40 and consists of 100 contracts worth $0.40 each. So a trader can buy each option for $40. So now there are only two outcomes for any trader that buys the option:

All other outcomes regarding TSLA’s price are irrelevant—the price could be $1,800 on the expiry date, but the payout would still be $100. So, in a similar manner as traditional American options, you bet on future outcomes with binary options, except the payouts are fixed based on a binary (yes or no) condition. 

Note that most binary options in real life are short-term, and weekly contracts are usually the longest that you can buy on platforms like Nadex.   

What is Hedging? 🌳

Fun fact—hedge funds are called hedge funds because they were once notorious for hedging their funds.

Hedge funds would often take conflicting positions on the same asset. This strategy is called hedging—you take multiple opposite positions on the same trade to ultimately reduce the overall risk (while also limiting the potential profits slightly). 

In the early days, it was a noble form of risk management. With hedging strategies, traders could protect themselves against enormous losses while only paying a small premium on big profits. Today, it is essential for traders to be aware of, if not utilize, hedging strategies.

So how does taking multiple opposite positions minimize risk? Let’s find out.

How Does Hedging Minimize Risk? ⚠️

To understand how hedging minimizes risks, imagine a house on fire. 🚒

Adam, a millennial homeowner, is standing nearby and looking at the burning wreck of an investment worth hundreds of thousands of dollars. Countless shifts of two jobs, years of eating ramen noodles for dinner, and stealing his brother’s Netflix—all up in flames. 🔥

As the fire keeps raging, the value of the house decreases every second. Yet Adam is not too worried. He safely made his way out of the house with his Labrador, and he also had an excellent home insurance policy that covered these situations. 

Adam minimized his risk of holding that asset by opting in to get a massive payout if an unlikely event wiped out 90% of his net worth. Essentially, he hedged the value of the house by taking a bet on it burning down.

For financial markets, hedging works pretty much the same way—except you’re Adam, your portfolio is the house, and derivatives (options and futures) are the insurance policy. Additionally, you can hedge both long and short positions in financial markets. In contrast, you can only hedge against the house dramatically losing value with home insurance.

Unlike a straightforward home insurance policy where you only have to pay an annual premium, hedging your trades is a bit more complex. And there are countless strategies that you can apply.  

There’s a lot to learn about options and futures trading. However, we’re going to focus only on hedging using binary options in this article.

Hedging Stock Positions Using Binary Options 📊

Binary options can be used to hedge both long and short positions. Let’s take a look at two examples to see how they mitigate your risk in both scenarios.

Hedging a Long Position with Binary Options 🏛️

Let’s say you live in a financial fantasy and have anticipated the AMC to pump back in May 2021. So you decide to make a bet and buy 1,000 AMC shares. You manage to buy them for $10 / share and plan to sell them if it hits $40.

However, you’re also not too sure about the potential upside and want to ensure that your losses are minimized. 

You decide that if the price hits $7, you will sell the shares and take a loss of $3,000 on the trade. So, being the responsible and savvy investor you are, you set a stop-loss for the trade at $7.

Here’s an overview of the trade and the overall risk you face:

• ☑️ Investment – $10,000 (1,000 shares at $10).
• ☑️ Planned exit and profit – $40,000 (1,000 shares at $40)
• ☑️ With stop-loss at $7, the maximum loss suffered would be $3,000 ($10,000 – $7,000).

In this case, we will use a binary put option to minimize our potential loss.

As you have a long position, your holding will increase in value as the price moves up. On the other hand, a binary put option pays out if the stock’s price falls below the strike price. Thus, you can hedge against the loss if the stock’s price hits your exit price by mixing the two. 

Let’s say you find a $10 AMC binary put option (consisting of 100 contracts worth $0.10) that offers a payout of $100 with a strike price of $7.05 and expires within a month. You’ll make a profit of $90 ($100 return – $10 option premium) if the price falls below $7.05 and lose the premium in case the price does not fall below the strike price.

You have already decided that your maximum risk in the AMC trade is $3,000. You can use binary options to execute the same trade but limit your total potential loss. To do that, we first need to find the number of options we should buy to mitigate our risk. 

• ☑️ Dollar value risk that needs to be hedged – $3,000
• ☑️ Profit per binary put option – $100
• ☑️ Number of binary options required – 30 (3000 / 100)
• ☑️ Total cost of hedging – $600 (30 * $20)

Now let’s look at all the possibilities and see how our future can look.

Few Things to Take Away 🚀

1. The minimum risk has now been reduced to just $600 instead of $3,000 with the binary option involved in the mix. 
2. 0, the only risk remaining is that you’ll lose the premium paid for the option if the price does fall below $7.05.
   
3. While the option minimizes your risk, it also limits your profit. For example, when AMC hit $15, your net profit would be affected by the premium you paid. Usually, you would have made $5,000 without the premium instead of $4,600 with it.
   
4. However, as the price keeps rising, your profits keep increasing, but the premium stays fixed. In this case, if your plan was to hold till $40, the premium paid would be effectively negligible in terms of profit.
   
5. The stop-loss order needs to be triggered, and you have to get out of the trade if the price hits $7. Suppose the price keeps dropping and your positions are still open. In that case, you will keep losing money, and the hedge would be useless in mitigating losses.

Hedging a Short Position with Binary Options 📈

Similarly, you can use binary options to hedge your short positions too. To understand this, let’s look at the example from the perspective of a trader that wants to short AMC when it is at $10.

Let’s say the trader plans to take profit if the price hits $5 and wants to get out of the trade if the price hits $12. She intends to short 1,000 shares, making her maximum tolerable loss $2000 ($12,000 – $10,000). 

Conveniently, there’s a $20 binary call option (100 contracts each worth $0.20) that pays $100 with a strike price of $12 and expires in a month. By using the same math above, we can determine that the trader would need to buy 20 (2000 / 100) options to mitigate against a loss of $2,000. Thus, the total hedging cost (option premiums) would be $400 (20 * 20).

Let’s see how the math checks out:

In this case, we hedge against a short position, but the core idea remains the same. Similarly, you’ll still encounter a loss if AMC does hit $12, but it’ll be relatively minor with the hedge. 

As with the previous example, the short position should also be immediately closed when AMC hits $12 for this strategy to work. Otherwise, the losses from the short position will keep accumulating. They can end up significantly more significant than what you’ve hedged against.

Hedging Binary Options with Binary Options

You can use several types of binary options, but let’s start with focusing on the vanilla put and call options that you are probably already familiar with and see how hedging using multiple options works.

Let’s take the example of EUR/USD and assume the rate to be 1.170 at the moment. Then, instead of taking a short or long position, you plan on taking opposite positions here with the assumption that the price will fluctuate between 1.170 and 1.185. 

In this case, you use two options:

1. The Binary Call Option: Strike price of 1.185, pays out $1 for each contract that costs $0.60. The option is sold in sets of 100 contacts which means each option pays out $100 and costs $60.
   
2. The Binary Put Option: Strike price of 1.175, pays out $1 for each contract that costs $0.60. The option is sold in sets of 100 contacts which means each option pays out $100 and costs $60. 

We assume the price will be between $1.14 and $1.19 and expect both options to expire in the money, so we buy 5 call options and 5 put options for a total investment of $600. Let’s look at how our hedging strategy would work out:

We expect both options to pay out and net us a profit of $400 (66.6%) on our investment in this trade. If the price goes out of our expected range, at least some of our options will still pay out, limiting our maximum loss to only $100 (16.66%).

Note that trading in real life doesn’t usually work out as neatly. For example, some of the top binary options brokers also might have rules regarding purchasing conflicting binary options on the same stock in the same trade. Fortunately, there are several other ways to hedge binary options, but they can get complicated.

Other Ways to Hedge Using Binary Options 📉

You can use several types of binary options in your trading strategy for hedging other than just call and put options. For example, a double barrier binary option allows you to pick an upper and a lower price. As long as the price does not touch either of the two bounds, you get the payout. 

A double barrier binary option on EUR/USD with a lower limit of 1.174 and an upper limit of 1.186 that costs $60 and pays out $100 would effectively create the same outcome as the example in the previous section, except in this case, you lose your entire investment if the price goes outside the range. However, you also receive a $1,000 payout if the price stays within the range.

It’s important to note that a double barrier binary option is a single bet and is not a hedged position. In this case, your losses will be absolute if you lose the bet, and your profits are also significantly higher. However, it is possible to hedge your stock positions using this type of option to create a more optimal hedging strategy.

Another approach to hedging with binary options is by using different platforms—for example, using one of the leading forex brokerages to open a position and then setting up the hedge position on your binary options trading platform. Similarly, you can open one position on your stock brokerage and hedge against it by opening an opposite position on the binary options platform.

It is also possible to take conflicting positions on two assets that are closely related. For example, EUR/USD and GBP/USD are usually correlated (move in the same direction). However, as they are still two different assets, you’re free to take conflicting positions to hedge on a platform where taking conflicting positions is not possible. 

Hedging Forex Using Binary Options 💲 

As seen in the previous example, binary options—in and of themselves—can be an effective hedging tool for forex trading. You can find binary options on all popular currency pairs like EUR/USD, USD/JPY, and USD/CAD on platforms like Nadex. 

The core logic of hedging using binary options remains the same for forex. You can use call options to hedge short positions and put options to hedge long positions.

Let’s take a look at a few situations where binary options hedging with forex can be helpful:

You’re Long but Losing 💰

Let’s say you’re bullish on USD/EUR and have a long and highly-leveraged position on the pair. However, you just received some news that might reverse the trend very quickly and make you unable to exit the trade without a loss. Since you’re trading with leverage, losing the bet can have disastrous consequences.

In this case, you can simply use put binary options to cover your losses significantly if USD falls significantly against your expectation. 

You’re Short but Losing 💳

Similarly, let’s say you’re bearish on USD/EUR this time and have a short and highly-leveraged position on the pair. However, something drastic happens, and things do not go your way. Instead of falling, the USD is rising. In this case, you can quickly hedge your position with binary put options to mitigate your loss.

Buying/Selling Multiple Options to Lower Risk and Potential Rewards 🤑

Suppose you’re betting on a highly volatile currency pair. In that case, you can buy and sell multiple options to finish in the money for both. 

For example, let’s say you think USD/JPY (currently trading at 109.4) is a particularly volatile pair and believe that the price will fluctuate between 109.5 and 109.8. So you can acquire a call option with a strike price of 109.8 and a put option with a strike price of 109.5. You get payouts from both options if you made the correct assumption and the price touches the two strike prices before expiry. 

Why Use Binary Options to Hedge 💭

Now that we have covered how binary options can be used in hedging, you might be wondering why to use binary options to hedge at all. For example, you might be wondering why not use traditional options for hedging instead? 

While we recommend exploring all options (pun intended), a few things make binary options unique, such as a huge payoff and low capital requirements, but there are also some drawbacks. In the following table, we look at the pros and cons.

So, binary options are not without risk. As they’re a relatively new financial instrument, the regulations have not caught up entirely yet. As a result, there are indeed frauds and scams out there involving binary options. 

Yet, they can be used as an effective hedging tool if you have done your research and have the financial discipline to execute the strategy flawlessly.

Conclusion 🏁

Risk is a significant aspect of trading and investing. Therefore, it is wise to seek ways to mitigate and control it in volatile markets. While binary options are definitely not for everyone, they can be a quirky yet effective way of managing risk across multiple markets—if you know what you’re doing.

However, traders should be aware of the hurdles involved in using binary options and the potential downsides. By reading this article and learning more about binary options, you’re already one step ahead of the competition. 

Get Started with a Binary Options Broker