Hedging Binary Options 2020

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How to Hedge Stock Positions Using Binary Options

Binary option trading had been only available on lesser-known exchanges like Nadex and Cantor, and on a few overseas brokerage firms. However, recently, the New York Stock Exchange (NYSE) introduced binary options trading on its platform, which will help binary options become more popular. Owing to their fixed amount all-or-nothing payout, binary options are already very popular among traders. Compared to the tradition plain vanilla put-call options that have a variable payout, binary options have fixed amount payouts, which help traders be aware of the possible risk-return profile upfront.

The fixed amount payout structure with upfront information about maximum possible loss and maximum possible profit enables the binary options to be efficiently used for hedging. This article discusses how binary options can be used to hedge a long stock position and a short stock position.

Quick Primer To Binary Options

Going by the literal meaning of the word ‘binary,’ binary options provide only two possible payoffs: a fixed amount ($100) or nothing ($0). To purchase a binary option, an option buyer pays the option seller an amount called the option premium. Binary options have other standard parameters similar to a standard option: a strike price, an expiry date, and an underlying stock or index on which the binary option is defined.

Buying the binary option allows the buyer a chance to receive either $100 or nothing, depending on a condition being met. For exchange-traded binary options defined on stocks, the condition is linked to the settlement value of the underlying crossing over the strike price on the expiry date. For example, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from the option seller, taking his net profit to ($100 – option premium paid). If the condition is not met, the option seller pays nothing and keeps the option premium as his profit.

Binary call options guarantee $100 to the buyer if the underlying settles above the strike price, while binary put option guarantees $100 to the buyer if the underlying settles below the strike price. In either case, the seller benefits if the condition is not met, as he gets to keep the option premium as his profit.

With binary options available on common stocks trading on exchanges like the NYSE, stock positions can be efficiently hedged to mitigate loss-making scenarios.

Hedge Long Stock Position Using Binary Options

Assume stock ABC, Inc. is trading at $35 per share and Ami purchases 300 shares totaling to $10,500. She sets the stop-loss limit to $30—meaning she is willing to take a maximum loss of $5 per share. The moment the stock price falls to $30, Ami will book her losses and get out of the trade. In essence, she is looking for assurance that:

  • Her maximum loss remains limited to $5 per share, or $5 * 300 shares = $1,500 in total.
  • Her pre-determined stop-loss level is $30.

Her long position in stock will incur losses when the stock price declines. A binary put option provides a $100 payout on declines. Marrying the two can provide the required hedge. A binary put option can be used to meet the hedging requirements of the above-mentioned long stock position.

Assume that a binary put option with a strike price of $35 is available for $0.25. How many such binary put options should Ami purchase to hedge her long stock position till $30? Here is a step-by-step calculation:

  • Level of protection required = maximum possible acceptable loss per share = $35 – $30 = $5.
  • Total dollar value of hedging = level of protection * number of shares = $5 * 300 = $1,500.
  • A standard binary option lot has a size of 100 contracts. One needs to purchase at least 100 binary option contracts. Since a binary put option is available at $0.25, total cost needed for buying one lot = $0.25 * 100 contracts = $25. This is also called the option premium amount.
  • Maximum profit available from binary put = maximum option payout – option premium = $100 – $25 = $75.
  • Number of binary put options required = total hedge required/maximum profit per contract = $1,500/$75 = 20.
  • Total cost for hedging = $0.25 * 20 * 100 = $500.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

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Best Binary Options Brokers: 2020 Ranking
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