Before we speak about binary options hedging, we need to understand the basic concept of hedging. Although hedging sounds like your neighbor’s hobby who’s obsessed with his topiary garden full of tall bushes shaped like giraffes and dinosaurs, hedging is a practice every investor should know about. There is no arguing that portfolio protection is often just as important as portfolio appreciation. Like your neighbor’s obsession, however, hedging is talked about more than it is explained, making it seem as though it belongs only to the most esoteric financial realms. Well, even if you are a beginner, you can learn what hedging is, how it works and what hedging techniques investors and companies use to protect themselves.
The concept of Hedging in trading?
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.
Hedging strategies are different forms of financial plans that allow a person to avoid unwanted price fluctuations in one market by establishing an opposite position in a different market. The overall goal is to limit the amount of risk faced when investing in different types of securities. A number of financial vehicles exist to benefit investors interested in hedging the chances of a large loss in markets. These include different types of options, forwards, swaps and insurance. Generally, hedging strategies involve the establishment of hedge funds to prevent the loss.
One of the primary components of hedging strategies is the concept of binary options. This enables investors to take a position that gives them the right to either buy or sell a certain asset at a specific price. The bonus of the options method is that the investor is not obligated to either sell or buy the financial security. Two types of options exist within this investment format: a put option and a call option. A put option gives the investor the right to sell at a given price, while a call option allows the investor to buy at a given price.
How Do Investors Hedge?
Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. We’re not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.
As a trader you know that most of the binary trades expire either at the end of the day or on hourly basis. If the price of a particular share is say $20 and you can earn a profit of $200, now if the prices go up as your prediction, within the hour before expiry, you have the option whether to hold the share or sell it before expiry. The decision of holding back the share depends on many factors. The future market depends on news and other sources of information which helps the traders analyze the market.
Now in this particular case, you can either use partial hedging or complete or full hedging. Full hedging implies selling of all the shares in this scenario. This would bring in the profits at the given moment. Partial hedging implies holding back some shares while selling a part of them. Although there is some risk attached as the trade to a certain extent is still open, but loss of risk on the shares sold is reduced. If at the time of expiry, the trader’s prediction is correct, he would still make the profit but without the involvement of any risk.
Keep in mind that because there are so many different types of options and futures contracts an investor can hedge against nearly anything, whether a stock, commodity price, interest rate and currency – investors can even hedge against the weather.
Binary options hedging concept
To begin with, binary options hedging strategies can be defined as the strategies that are designed to reduce the risk of investment by using put options, call options, future contracts or short selling methods. The basic purpose of using binary options hedging strategies is to reduce the risk and potential volatility of an investment or a portfolio by reducing the risk of loss. Hedging gives the benefit of locking in the existing profits.
Binary options hedging strategy is best understood with the following example:
A trader is trading the stocks of a company ABC and takes a contract of $100 with a strike price of $10 per share when placing their trades. Depending on the expiry terms, the trader is early in the trade, which means that there is still time left for the expiry time and the trade is “in the money”. The share price may have gone up to $10.75 or $11 per share. At this point of time, the trader might be skeptical whether to hold the position till expiry or lock in the gains. Volatile as it might be, there could be sudden changes at expiry time leading to a fall in share prices or there could be another surge of appreciation of prices.
The best approach would be to lock in at least some of the gains, is by making a partial or full hedge. If the trade is fully hedged the risk of loss is minimized whereas if the trade is partially hedged, the trade is still left open partially and the trader has the opportunity to still make good gains if his intuitions go correct.
Every hedge has a cost, so before you decide to use hedging, you must ask yourself if the benefits received from it justify the expense. Remember, the goal of binary options hedging isn’t to make money but to protect yourself from losses. The cost of the hedge – whether it is the cost of an option or lost profits from being on the wrong side of a futures contract – cannot be avoided. This is the price you have to pay to avoid uncertainty.
We’ve been comparing hedging versus insurance, but we should emphasize that insurance is far more precise than hedging. With insurance, you are completely compensated for your loss (usually minus a deductible). Hedging a portfolio isn’t a perfect science and things can go wrong. Although risk managers are always aiming for the perfect hedge, it is difficult to achieve in practice.
Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect themselves. Whether or not you decide to start practicing the intricate uses of derivatives, learning about how hedging works will help advance your understanding of the market, which will always help you be a better investor.
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