Binary Options Hedging Explained Profit Slowly but Safe
March 28, 2013 by Bogdan G
Full Review of Binary Options Hedging Strategy for Binary Options Trading
I’ve been thinking lately: being a good technical analyst but also aware of the fundamental aspects like news and economic data or political events will definitely make you a better trader…but not a complete one. In order to achieve the next level in our trading, we must learn to manage risk. There are different techniques of doing that, ranging from simple ones to extremely complex but the best are the ones that you can understand and comfortably use.
My friend Michael Hodges, aka “The Geek” shares my view on the need for controlling risk and extends a helping hand by explaining in detail a widely respected technique called Hedging. The full article can be found here: //tmhughes. hubpages/hub/Hedging-Strategies-For-Binary-Options-Traders First question that comes to mind is “What is hedging?” Michael offers a perfectly good and easy to understand explanation: “A hedge or hedging strategy is a financial position that seeks to lock in gains or prevent losses from trading and investing.” Ok so we learned that hedging can protect us against losses and lock in profits but how can we achieve that? The easiest way is by creating an off-set position, in other words, a Buy is hedged by a Sell and a Sell is hedged by a Buy. In Forex or Vanilla Options, perfect (or rather near perfect) hedges can be created but in Binary Options, it’s a bit harder. Anyway, a perfect hedge will bring zero profit so we don’t need it, I hope you agree. Don’t worry, we’ll get to the bottom of this soon.
If I try to hedge a Binary Call with a Binary Put, things aren’t so good for me because if I invest $100 on the Call and $100 on the Put, that adds up to a $200 investment. Assuming my payout is 70% and the Out of the Money refund is 15%, if price goes up I win $70 on the Call and lose $85 on the Put. The total result is a loss of $15 and that’s not so good. Same thing happens if price goes down so what we learn from this is that you cannot limit risk just by opening two opposite Binary Options trades with no bias. Ok, here’s where the Geek steps in to help by explaining that you need to have a direction in mind and only then apply the hedging strategy.
Let’s assume that our analysis points towards a bullish move so we invest $100 in a Call and in order to limit the risk, we invest some money in a Put…but a smaller amount. After all, our view is a bullish one and it is normal to invest more on the Call. This is the little trick proposed by the Geek and it’s a good one. In fact, without this twist, our hedge would just bring a loss. Ok, on the Put we only invest $50 so let’s do the math:
If my prediction is correct and market moves up:
I win $70 on the Call and I lose $42.5 on the Put (15% refund on a $50 investment is $ 7.50) for a total of $27.5 win ($70 $42.5 = $27.5)
If my prediction is not correct and the market goes down:
I lose $85 on the Call (I don’t lose the full $100 because the refund is 15%) and I win $35 (70% on a $50 investment) on the Put for a total loss of $50 ($35 $85 = -$50)
If we compare these results with un-hedged ones we will reach some conclusions about hedging and the “Suck” factor involved:
Why does Binary Options Hedging Suck
First and foremost, the potential profit is limited by hedging. Here comes math again: If I am correct in my prediction, I can win $70 on an un-hedged trade but by hedging it I will only receive $27.5. That’s less than half so some guys might think it’s not worth it. I think this is the only major negative thing about hedging but it all comes down to your appetite for risk.
Why Binary Options Hedging doesn’t Suck
Simple: it limits loss. The risk is decreased and for me decreasing risk is better than increasing the profit. On an un-hedged position, the potential loss is $85 but on the hedged combo, the loss is limited to $50. This for me seems like a fair trade and I’d take it anytime.