How to Hedge Stock Positions Using Binary Options

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How to Hedge Stock Positions Using Binary Options

Binary options (also known as digital options) have only been available on the New York Stock Exchange (NYSE) since 2016, but due to their fixed all-or-nothing payout, they are becoming popular among traders and gaining some interest from individual investors, particularly as a tool for hedging their stock positions.

Binary options, as opposed to classic plain vanilla put-call options with variable rewards, feature set sum payments, which makes the possible risk and return known up front.

That may make them seem easy, but make no mistake: binary options are an unusual financial tool that should not be taken lightly. The payment is indeed all or nothing.

Key Takeaways

  • Binary options are a sort of exotic option contract that pays out a defined amount if the underlying stock climbs over a certain threshold or striking price.
  • Binary options, unlike typical options contracts, do not execute or convert to the underlying shares or other assets.
  • Binary options may be used to hedge bets in the underlying stock, either long or short. In other words, they may be utilized to mitigate possible stock losses.
Image by Julie Bang © Investopedia2020

Quick Primer to Binary Options

Binary options, according to their literal nature, provide just two potential payoffs: a set sum ($100) or nothing ($0). An option buyer pays the option seller a sum known as the option premium to acquire a binary option.

Other common criteria of binary options are identical to those of ordinary options: a strike price, an expiration date, and an underlying stock or index on which the binary option is defined.

Purchasing a binary option gives the customer the opportunity to receive either $100 or nothing if a condition is satisfied. The condition for exchange-traded binary options specified on equities is the underlying’s settlement value passing over the strike price on the expiration date.

For example, if the underlying asset settles above the strike price on the expiration date, the binary call option buyer receives $100 from the option seller, representing a net profit of $100 less the option premium paid. If the condition is not satisfied, the option seller receives no payment and retains the option premium as profit.

Binary call options guarantee the buyer $100 if the underlying closes above the strike price, and binary put options guarantee the buyer $100 if the underlying closes below the strike price.

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If the condition is not satisfied, the seller profits in either event, retaining the option premium as profit.

Stock investments may be properly hedged to prevent loss-making circumstances using binary options offered on common equities trading on exchanges such as the NYSE.

How to Hedge a Long Stock Position Using Binary Options

Assume ABC, Inc.’s stock is trading at $35 per share. An investor spends $10,000 on 300 shares with a stop-loss limit of $30. That implies the maximum loss for the investor is $5 per share.

If the stock price falls, this long position will lose money. A binary put option, on the other hand, will pay out $100 if the price falls. Marriage between the two may offer the necessary hedging.

To fulfill the hedging needs of the previously indicated long stock position, a binary put option might be deployed.

Assume you can get a binary put option with a strike price of $35 for $0.25. How many of these binary put options should the investor buy to protect his long stock position? Here’s a step-by-step formula:

  • Required level of protection = maximum allowable loss per share = $35 – $30 = $5.
  • Total hedging value = level of protection * number of shares = $5 * 300 = $1,500
  • A basic binary option lot is 100 contracts in size. At least 100 binary option contracts must be purchased. Because a binary put option is available for $0.25, the total cost for purchasing one lot is $0.25 * 100 contracts = $25. This is often referred to as the option premium amount.
  • Maximum binary put profit = maximum option payment – option premium = $100 – $25 = $75
  • Total hedge necessary/maximum profit per transaction = $1,500/$75 = 20 binary put options required.
  • Hedging costs total $500 ($0.25 * 20 * 100).

Here is the scenario analysis based on the various underlying price levels at the time of expiry:


Underlying Price at Expiry



Profit/Loss from Stock



Binary Put Payout



Binary Put Net Payout



Net Profit/ Loss



(a)



(b) = (a – buy price) * quantity



(c)



(d) = (c) – binary option premium



(e) = (b) + (d)



20.00



-4,500.00



2,000.00



1,500.00



-3,000.00



25.00



-3,000.00



2,000.00



1,500.00



-1,500.00



30.00



-1,500.00



2,000.00



1,500.00



0.00



32.00



-900.00



2,000.00



1,500.00



600.00



34.99



-3.00



2,000.00



1,500.00



1,497.00



35.00



0.00



0.00



-500.00



-500.00



38.00



900.00



0.00



-500.00



400.00



40.00



1,500.00



0.00



-500.00



1,000.00



45.00



3,000.00



0.00



-500.00



2,500.00



50.00



4,500.00



0.00



-500.00



4,000.00



55.00

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6,000.00



0.00



-500.00



5,500.00

None

Where,


Stock Buy Price =



$35



Stock Quantity =



300



Binary Option Premium =



$500

None

Without the hedging provided by the binary put option, the investor may have lost up to $1,500 at the stop-loss level of $30 (as shown in column (b)).

At the underlying price level of $30, the loss is restricted to $0 by hedging with an additional $500 in binary put options (as shown in column (e)).

A Consideration for Real-Life Trading Scenarios

  • Hedging is not free. It protects against losses but decreases net profit if the stock is lucrative. This is evidenced by the difference in values in columns (b) and (e), which represent (profit from stock) and (profit from stock + binary put option), respectively. Column (b) values are greater than those in column (a) above the stock profitability scenario (underlying price exceeding $35). (e).
  • A predetermined stop-loss level is also required for hedging. Calculating the appropriate binary put option amount for hedging is required.
  • In the example, if the predetermined stop-loss level of $30 is reached, the investor must square off the positions. If not, losses will continue to rise, as seen in rows 1 and 2 of the table above, which correspond to underlying price levels of $25 and $20, respectively.
  • Brokerage fees must be considered since they may have a substantial influence on the hedged position, profit, and loss.

How to Hedge a Short Stock Position Using Binary Options

Assume the investor is short 400 shares of a company with a selling price of $70 in this example. The investor wishes to hedge up to $80, implying that the maximum loss is ($70 – $80) * 400 = $4,000.

This means:

  • The needed amount of protection is equal to the maximum allowable loss per share, which is $80 – $70 = $10.
  • The entire cash worth of hedging is equal to the amount of protection multiplied by the number of shares, which is $10 multiplied by 400 equals $4,000.
  • Assuming a binary call option with a strike price of $70 is offered for a $0.14 option premium, the cost of purchasing one lot of 100 contracts is $14.
  • The maximum profit on a binary call is equal to the maximum option payment minus the option price, which is $100 minus $14 = $86.
  • The total hedge required/maximum profit per contract is $4,000/$86 = 46.511, rounded down to 46 lots.
  • The total cost of hedging is therefore $0.14 * 46 * 100 = $644.
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Here is the scenario analysis based on the various underlying price levels at the time of expiry:


Underlying Price at Expiry



Profit/Loss from Stock



Binary Call Payout



Binary Call Net Payout



Net Profit/ Loss



(a)



(b) = (sell price – a) * quantity



(c)



(d) = (c) – binary option premium



(e) = (b) + (d)



50.00



8,000.00



0.00



-644.00



7,356.00



55.00



6,000.00



0.00



-644.00



5,356.00



60.00



4,000.00



0.00



-644.00



3,356.00



65.00



2,000.00



0.00



-644.00



1,356.00



70.00



0.00



0.00



-644.00



-644.00



70.01



-4.00



4,600.00



3,956.00



3,952.00



75.00



-2,000.00



4,600.00



3,956.00



1,956.00



80.00



-4,000.00



4,600.00



3,956.00



-44.00



85.00



-6,000.00



4,600.00



3,956.00



-2,044.00



90.00



-8,000.00



4,600.00



3,956.00



-4,044.00



100.00



-12,000.00



4,600.00



3,956.00



-8,044.00

None

Where,


Stock Short Sell Price =



$70



Stock Quantity =



400



Binary Option Premium =



$644

None

In the absence of hedging, this investor would have lost $4,000 at the $80 stop-loss level (as represented by the column (b) value).

The loss is restricted to $44 by hedging with binary call options (as stated by the column (e) value).

Ideally, this loss should have been zero, as shown in the first section’s binary put hedging example. The $44 loss is the result of rounding down the needed number of binary call options. The computed number was 46.511 lots, which was rounded down to 46 lots.

The Bottom Line

Call and put options, as well as futures contracts, have long been employed as hedging instruments. Binary options provide an additional tool for investors looking to hedge possible losses on actively traded companies.

The preceding examples, one for hedging long stock holdings and one for hedging short stock positions, demonstrate the potential efficacy of employing binary options.

With so many different instruments to hedge, traders and investors should choose the one that best meets their goals at the lowest possible cost.

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