Complete Guide to Binary Options Hedging Strategy.
Hedging a binary option involves buying both a put and a call on the same financial instrument, with strike prices that allow both to be in the money at the same time. That is, the strike price of the binary call option is lower than the strike price of the binary put option. Consider what this means.
What is Binary Options Hedging Strategy?
When you buy a binary call option, you are allowed to buy a financial instrument at a certain price, the strike price. When you buy a binary put option, you are allowed to sell a financial instrument at a certain price, the strike price. If the financial instrument you want to buy or sell is initially worth more than the strike price, then you’ll make a profit as soon as the binary option expires. But what if the financial instrument you want to buy or sell is initially worth less than the strike price? You’ll be out of pocket as soon as the binary option expires.
For example, consider two binary options, the first on the price of an individual share. You buy a binary call option on the shares with the strike price of _100, and the price of the share at the time you do this is _125. You will then lose _25 for every _1 you paid for the binary call option. If it’s a $100 binary call option and the price of the share is $80 when you do this, you will lose $20 for every $1 you paid for the binary call option.
Now consider two binary options, one on the price of an individual share, the other on the price of the same share. You buy a binary call option with the strike price of _100, and you buy a binary put option with the strike price of _100. You will then lose nothing if the share price is initially less than _100, and you will lose nothing if the share price is initially more than _100.
It’s the same with all hedging strategies. In this example, the put and call options can be thought of as the binary put and call options on a single financial instrument. The strike price of the binary call option and the binary put option, when added together, are equal to the strike price of the hedged binary call and put. If the hedged option goes up, then the individual binary option goes up by the same amount. If the hedged option goes down, then the individual binary option goes down by the same amount.
This would be a good time to point out that you don’t need to own the actual binary put and call options in order to hedge a binary option. If you do this, you save on the commission expense, but you are open to the risk that the broker in question will go out of business before your binary option expires. Simply buy the hedged option if your broker allows this.
NOTE! You can buy a call and put option on the same financial instrument with the same strike price, but they are not hedged. They move in opposite directions, and you will lose money.
The "Strategy" Part of the Hedging Strategy.
There are many different routes you can take when you are considering a hedging strategy on a binary option, and actually, hedging goes beyond binary options. Many experienced investors hedge binary options, but they also hedge other financial instruments. However, there is no need to get bogged down in the complexity of these strategies, which are far beyond the scope of this article. All you need to understand is how the strategy works.
For example, consider an investor who wants to buy shares in Company A. The strike price of the binary call option is _20, and the price of one share in this company is currently _10. He therefore buys a binary call option and a binary put option. The strike price of the binary call option is _20, and 1 share in Company A is worth _10, so the strike price of the underlying binary call option is equal to the price of a single share in Company A. Therefore the strike price of the binary put option is equal to _10. In other words, the investor makes money immediately because he bought a binary option where the strike price of the underlying binary option is less than the strike price of the hedged binary option.
It was explained earlier that when you buy a binary call option, you are buying the right to buy a financial instrument at a certain price. In the example, this is the right to buy a share in Company A at _20. If the price of a share in Company A is _20 when the binary option expires, you will make a profit of _20.
Now consider another scenario. Again, the investor wants to buy shares in Company A, and again, the price of one share in Company A is _10. He buys a binary call option with the strike price of _10. Again, this makes money because _10 is less than the strike price of the binary call option.
However, the strike price of the binary put option is _20, so this doesn’t work. The investor can make money on a binary put option if the price of the financial instrument goes down, and the strike price is higher than the price of the financial instrument when the binary option expires.
So, the investor buys a binary put option, with the strike price of _10. When the binary put option expires, the investor now has the right to sell one share in Company A at _10. When the investor buys the binary put option, the strike price is _10, and one share in Company A is _10. This means the strike price of the binary put option is equal to the price of a single share in Company A. The investor has a right to sell a share in Company A at _10, and one share in Company A is _10. The investor will make a profit if the price of a share in Company A is higher than _10 when the binary put option expires.
It is important to remember that in this example, the investor has already bought the binary put option with the strike price of _10. When he wants to hedge the binary put option with the strike price of _10, he needs to buy the binary call option with the strike price of _10. If the price of a share in Company A is _20 when the binary put option expires, the investor will lose _10. However, this is offset by the profit of _10 that he made earlier when he bought the binary put option with the strike price of _10. Therefore, the investor makes a profit when the price of a share in Company A goes up, and the investor makes a profit when the price of a share in Company A goes down.
The Bottom Line.
There are several different strategies you can use to hedge a binary option. You can hedge a binary call option using a binary put option and the opposite way around, and you can even hedge a binary option by buying the call and put option on the same financial instrument with the same strike price. As long as the strike price of the binary put option is the opposite of the strike price of the binary call option, then you will always make a profit. The only time you will make a loss is when you have an actual straight up or down bet.
The question is whether you should hedge a binary option, and the answer is a resounding "No." If you’re going to hedge a binary option, you need to go beyond binary options. Hedge binary options with other financial instruments.