Hedging with Fences
You’ve probably heard the phrase “hedge your bets.” When it comes to binary options trading, you should never be betting, but rather making educated decisions in order to reduce the risk of random chance deciding whether or not you are going to make money. There is some randomness in the markets, but the more you can reduce this, the better. That’s why hedging is a must in some instances. The catch here is that hedging properly is extremely difficult and something that only advanced traders should be attempting.
With that said, there are several different kinds of hedging strategies when it comes to binary options. The one that we’re going to discuss here is called fencing. It’s called fencing because it allows you to “fence” in your profits, just like you would keep your dog in your yard by enclosing him. It’s best explained with an example.
Let’s say that you are trading an asset that is currently priced at $50. You predict that over the next 20 minutes, the price of that asset will go up. You take out a call option for $100 with an expiry of 30 minutes and wait. You have locked in a profit rate of 80 percent. After 20 minutes, you find that you were initially correct in your prediction and that the price has gone up to $60, but now there are 10 minutes left in the life of the trade, and the price is beginning to drop. At this point, you take out a put option on the same asset for 10 minutes. If you assume the same rate of return at 80 percent, but you are able to get a put option on the asset at $55, you are now at an interesting place. There’s only a few minutes left in the life of both trades, and as of this moment, you are in the money on both of them. If the price finishes above $50, you earn $80 on the call. If the price finishes below $55, you earn $80 on the put. If it finishes in between $50 and $55, you earn $160 as both were correct. You have fenced in the price and have guaranteed a profit either way.
This method of hedging is powerful because it is so simple to apply. However, that doesn’t make it foolproof.
As you’ve probably guessed, there are some drawbacks to this strategy. The biggest is the fact that most people will use this strategy needlessly and thus end up costing themselves money for no reason. You are giving yourself the little insurance of having at least one trade right, but just because one trade earns money does not mean that you will be profitable overall. Having one right trade and one wrong will end up losing you a total of $20 using this method. That’s better than losing $100, but it’s certainly still a loss. The allure of finishing in the money on both trades will make up for this in most people’s eyes, but this doesn’t happen often enough to be worth the risk. If you use a strategy like this, it’s something that should be done sparingly, and not as a default strategy. It’s a very simple thing to understand, but if you don’t use it right, you will end up nickel and diming yourself into the red. This should be left to only top level traders that are able to analyze a trade and use it only in the most appropriate settings.
Another drawback is that if things are not timed right, both trades stand a danger of being losers. This isn’t likely, but it can happen if you are not careful. Again, it’s something that only experienced traders should attempt, especially because if you get caught up in the heat of the moment, there is a higher likelihood of making mistakes. If this does happen, you suddenly double your losses, which is obviously not a good thing.