How to use binary options to hedge stock positions

They have only been listed on the New York Stock Exchange (NYSE) since 2016, but due to their fixed all-or-nothing payment, binary options (also known as digital options) have become more and more popular among traders and have caused Some interest of individual investors, especially as a tool for hedging stock positions.

Compared with traditional ordinary put options with variable expenditures, binary options have a fixed amount of expenditure, which makes the potential risks and rewards clear in advance.

This may make them seem simple, but make no mistake: Binary options are a bizarre financial instrument, not for the faint-hearted. Payment is really all or nothing.

Key points

  • Binary option is a peculiar option contract. If the underlying stock exceeds the set threshold or strike price, it has fixed expenses.
  • Unlike traditional option contracts, binary options will not be exercised or converted into underlying stocks or other assets.
  • Binary options can be used to hedge long or short positions in the underlying stocks. In other words, they can be used to reduce potential inventory losses.

Quick Start for Binary Options

According to the literal meaning of the term “binary”, binary options only provide two possible returns: a fixed amount ($100) or none ($0). To buy a binary option, the option buyer pays an amount called the option premium to the option seller.

Binary options have other standard parameters similar to standard options: strike price, expiration date, and the underlying stock or index that defines the binary option.

Purchasing binary options allows the buyer the opportunity to get $100 or nothing, depending on the conditions met. For exchange-traded binary options defined on stocks, this condition is associated with the settlement value of the underlying intersection on the expiry date.

For example, if the settlement price of the underlying asset is higher than the strike price on the expiry date, the buyer of the binary call option receives $100 from the option seller, and the net profit is $100 minus the premium paid. If the conditions are not met, the option seller does not pay any fees, and retains the option premium as profit.

If the underlying is settled at a higher than the strike price, the binary call option guarantees the buyer 100 USD, and if the underlying is settled at a lower than the strike price, the binary put option guarantees 100 USD to the buyer.

In either case, if the conditions are not met, the seller will benefit and keep the premium as profit.

By providing binary options on common stocks traded on exchanges such as the New York Stock Exchange, stock positions can be effectively hedged to reduce losses.

How to use binary options to hedge long stock positions

  • Assume that the trading price of the stock ABC, Inc. is $35 per share. The investor buys 300 shares at a total price of US$10,500 and the stop loss limit is US$30. This means that the investor’s maximum loss will be $5 per share.

If the stock price falls, the long position of the stock will suffer losses. However, if the price falls, the binary put option will provide a payout of $100. Combining the two can provide the required hedging.

Binary put options can be used to meet the hedging requirements of the aforementioned long stock positions.

Assume that the price of a binary put option with a strike price of $35 is $0.25. How many such binary put options should investors buy to hedge their long stock positions? Here is a step-by-step calculation:

  • The level of protection required = the maximum acceptable loss per share = $35-$30 = $5.
  • The total USD value of the hedge = protection level * number of shares = 5 USD * 300 = 1,500 USD.
  • The standard binary option lot size is 100 contracts. One person needs to buy at least 100 binary options contracts. Since the price of a binary put option is 0.25 USD, the total cost required to purchase a batch = 0.25 USD * 100 contracts = 25 USD. This is also called the premium amount.
  • The maximum profit of a binary put option = the maximum option payment-option premium = 100 USD-25 USD = 75 USD.
  • The number of binary put options required = total hedging required / maximum profit per contract = 1,500 USD / 75 USD = 20.
  • The total cost of hedging = 0.25 USD * 20 * 100 = 500 USD.

The following is a scenario analysis based on the different price levels of the subject matter at the time of expiry:

Maturity base price

Inventory gains and losses

Binary Put Payment

Binary Put Net Income

Net profit/loss

(One)

(b) = (a-purchase 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

6,000.00

0.00

-500.00

5,500.00

Where,

Stock purchase price =

35 USD

Inventory quantity =

300

Binary option premium =

500 USD

Without the hedging provided by binary put options, investors could suffer losses of up to $1,500 at the $30 stop loss level (shown in column (b)).

With an additional $500 binary put option hedging, the loss is limited to $0 at the underlying price level of $30 (as shown in column (e)).

Consideration of real trading scenarios

  • Hedging comes at a price. It provides protection from loss, but if the stock is profitable, it will also reduce net profit. This can be demonstrated by the difference between the values ​​in columns (b) and (e), which show (stock profit) and (stock profit + binary puts) respectively. Above the stock profitability (base price is higher than 35 USD), the value in column (b) is higher than the value in column (e).
  • Hedging also requires a predetermined stop loss level. The number of binary put options required for hedging needs to be calculated.
  • In this example, if the predetermined stop loss level of $30 is reached, the investor must close the position. Otherwise, the loss will continue to increase, as shown in the first and second rows of the above table, corresponding to the basic price levels of $25 and $20.
  • Brokerage fees must be considered because they can significantly affect hedging positions, profits and losses.

How to use binary options to hedge short positions

In this example, suppose that an investor shorts 400 shares of a stock at a price of $70. Investors want to hedge a maximum of 80 USD, which means that the maximum loss is (70-80 USD) * 400 = 4,000 USD.

this means:

  • The level of protection required is equal to the maximum possible loss acceptable per share, which is $80-$70 = $10.
  • The total dollar value of the hedge is equal to the protection level * the number of shares, that is, $10 * 400 = $4,000.
  • Assuming that a binary call option with a strike price of $70 can be obtained at an option fee of $0.14, the cost of buying 100 contracts will be $14.
  • The maximum profit of a binary call option = the maximum option payout-option premium = US$100-US$14 = US$86.
  • The number of binary call options required is equal to the total hedging required/the maximum profit per contract, which is 4,000 USD/86 USD = 46.511, rounded to 46 lots.
  • Therefore, the total cost of hedging is USD 0.14 * 46 * 100 = USD 644.

The following is a scenario analysis based on the different price levels of the subject matter at the time of expiry:

Maturity base price

Inventory gains and losses

Binary call payment

Binary call network payment

Net profit/loss

(One)

(b) = (selling 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

Where,

Stock short selling price =

70 USD

Inventory quantity =

400

Binary option premium =

USD 644

Without hedging, the investor would suffer a loss of US$4,000 at the stop loss level of US$80 (indicated by the value in (b)).

Through hedging, using binary call options, the loss is limited to $44 (represented by the value in column (e)).

Ideally, this loss should be zero, as observed in the binary put option hedging example in Part 1. The loss of $44 is due to rounding of the required number of binary call options. The calculated value was 46.511 lots and was truncated to 46 lots.

Bottom line

Ordinary call options and put options and futures have traditionally been used as hedging tools. Binary options add a tool for investors seeking to hedge potential losses on stocks with large trading volumes.

The above example, one used to hedge a long position in stocks and one used to hedge a short position in stocks, illustrates the potential effectiveness of using binary options.

With so many different hedging tools, traders and investors should choose the tool that best suits their needs at the lowest cost.




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