Cheat Sheet 6: Hedging Strategies For Your Binary Option Positions
*** Update July 2014: A new software was released to automate this binary hedging strategy, check out the Automated Binary Hedging Strategy Video Here ***
Binary options trading in general presents an unfavorable risk profile for aspiring binary traders. The typical binary options trading platform offers returns in the 60% to 81% range for winning trades and losses of 85% to 100% for losing trades, definitely not an attractive risk/reward ratio for those looking to have any type of longevity trading binary options. But fear not, there are several strategies the binary options trader can implement to change the general risk profile into something more manageable, a risk profile designed to take small losses when necessary and to generate sizable gains when the odds shift to your favor.
The most common hedging strategy used in binary options trading is one in which you first purchase a binary put or call, then if the stock moves in your desired direction you buy the opposing binary put or call to lock in a “profit zone”. This is illustrated in the graph below:
As can be seen in the graph, we initially purchased an Amazon (AMZN) binary call option with a strike of $125 at 11:10 am. With shares of Amazon looking pretty volatile we decided to buy an Amazon binary put option with a strike of $126 immediately before the “lock-out” time of 11:45. So what does that do to our risk profile? No longer are we constrained by the [+70%, -85%] return profile, we now make 70% with shares of Amazon trading between $125 and $126 and lose 15% with shares of Amazon trading anywhere outside of that range. While the “profit zone” may seem small, the risk of losing big has been significantly reduced.
The key to profitably trading binary options is knowing when to be aggressive (letting it ride) and knowing when to cut your losses and live to fight another day (place another trade).
In this example we made 2 significant assumptions, 1) the stock moves in your desired direction, and 2) the lot size of both trades was equal. In terms of the first assumption, clearly the stock is not going to always move in your desired direction and thus this hedge strategy will not be applicable when you don’t pick the initial stock direction correctly. In these circumstances there are alternative strategies we can use to alter the risk profile. We delve into those strategies next week.
As for the second assumption, no one said you needed to trade the exact same lot size for your hedge trade. Here’s how we approach it. If the stock had moved sufficiently far enough in the money we would in all likelihood let it ride, risking an 85% loss over the lock-out period. If risking an 85% loss on a high probability winner still doesn’t appeal to you, we would suggest purchasing the complementary binary put or call using a lot size that is smaller than the original. For instance say you initially purchased the Amazon $125 strike call for $100 and it is now 11:44 and shares of Amazon are trading for $126. Instead of spending $100 to purchase the put hedge, what would spending $50 for the put hedge do to your risk profile? Let’s take a look:
As can be seen, the maximum potential loss has increased in this alternative hedge structure (-33% vs. -15%), though it is still much lower than the general one trade option maximum potential loss of -85%. In return for the increased loss potential, the area of profitability has increased substantially to include everything above the initial $125 strike. With shares of Amazon trading between $125 and $126 you would bank $105 (70%) and with shares trading above $126 the total return would be $28 (19%). There are several ways to alter your risk profile by changing the lot size of the complementary trade. The goal is to find the risk profile most appropriate for your risk tolerance.