This article can show you the advantages of hedging put options using binary options, as well as explain you how it works. Put options guarantee their holders the right – but not the obligation – to sell a security under predetermined conditions (conditions pertaining to the amount, price, time frame etc.). The call option is the counterpart of put option. Generally speaking, put options are only profitable as long as the strike price is higher than the underlying price. If not, the option is practically worthless, so holders usually opt for some kind of insurance against this in order to protect their investment – something that will guarantee a stable positive payout if the underlying price increases. That instrument can be a binary call option. This is where hedging comes in.
How to hedge put options?
In order for binary options hedging to work, you need to figure out three things: the initial number of binary options you need to cover the long puts; the number of binary options it takes to cover the cost of hedging and account for additional binary options will you need in case you have to adjust the final price. After adding up all three, you get the total number of binary options you will require for hedging. Just remember to make sure your binary options profit can cover the costs of the endeavor, if not – you need more options. This strategy helps you cover all angles, after all…
By acquiring a sufficient number of binary call options to counter risks of your ordinary put options ensures that you can come out ahead at any underlying price. Yes, underlying price that is higher than the strike price are extremely unfavorable for your put options, but on the other hand, they can be just as favorable for your call options, even binary call options. The way this works is that if you combine enough (regular) call and binary put options, you can cover both angles, both outcomes – as long as the profits on your binary call options exceed costs incurred by the total trade, you are set – you cannot lose.
There are two possible outcomes: either the underlying price goes below the strike price, or it doesn’t. In the first case scenario, you activate your put options and make a huge profit. The binary call options you acquired to bet against yourself will be worthless, but since you combined them properly, the profits from your put options will far exceed the fixed amount you lost on your little “insurance policy”. In the second case scenario, your put options are worthless, but the fixed amount of money from your binary call options will cover any losses you’ve made – this is why you bought them in the first place.
Remember, the binary call options are there only to cover the trade costs you incurred in case your primary goal, the long put options, fails miserably. You’ll make less money, but never lose.