Binary options are a growing form of investment, simplifying the process of trading for many investors – but does the simplicity of a binary option open up opportunities beyond an introduction to trading? Could they, for example, be an ideal tool for risk management and hedging other investments ?
A hedge, in terms of investment, can be loosely defined as;
So hedging is a risk management strategy, offsetting an existing position in a related asset, or group of assets.
The most obvious “real world” example is an insurance policy. The policy protects the holder in the event of a particular event. In order to secure this protection however, the policy holder must pay for it. So a homeowner might insure their property, knowing that in the event of the property being damaged or destroyed, they would receive compensation. The trade off is that were nothing to happen to the property, the regular insurance premiums would erode some of the capital gains made.
The aim of hedging an investment then, is to mitigate any potential losses. Either from a particular event, or simply volatility. An investor may be cautious of a future event and wish to protect their investment. Simply closing and re-opening a position is not always easy, or cost effective. A trader may wish to continue holding their position, but simply apply some risk management.
This risk mitigation exercise could be necessary for a variety of reasons. A specific announcement, a global or domestic crisis, a key vote or any event – known or otherwise – that might affect the value of an asset.
So given the fundamental aim of hedging an investment – could a binary option offer a flexible method of hedging? With costs, and potential returns, established before the trade is placed, traders can manage their level of risk with huge accuracy.
Let us look at a simple, fictional, example;
Our trader has a large holding in HugeCorp Plc. There is a concern that an upcoming court ruling regarding a patent will significantly affect the share price, perhaps knocking 10% off the current value. The trader is confident the ruling will be made in favour of HugeCorp – but wants to mitigate the risk.
Our trader opens a binary trade – with an expiry date shortly after the date of the ruling. If the price is below today’s value at the point of expiry, the trade will return 95% on his investment. If the price on expiry is above today’s valuation, the binary option will lose. The size of the option can be tailored however the trader chooses, enabling the risk to be managed to a precise level.
Our trader has mitigated the risk of any adverse news. Should the ruling go against HugeCorp, the option pays off – reducing losses. If the news is good, the binary option will lose – but the original holding in HugeCorp will have risen in value, mitigating the small loss on the binary option trade.
A binary option then, can provide an excellent hedging tool, particularly when considering a specific event, where the date is known. More elaborate options could be used, beyond the simple Higher/Lower type. For example an In/Out option might be used to protect against flat markets or delayed events.
In order to use binary options for hedging purposes, traders need to be very selective with their broker choice. A fundamental part of the hedge will be the time frame. The majority of these ‘hedge’ investments will be longer term, or for a specific event. Either way, the trader will require a large element of flexibility from their broker. Some brokers will not provide long term expiry times at all, others may provide ‘set’ long term expiries, for example, 3 months from today’s date, or 6 months. Binary.com however, allow traders to set their own expiry date – any date they choose. This level of flexibility means traders can be very specific and ensure their positions expire exactly when they need them to – for example directly after a key announcement.
In summary then, binary options are a great tool for those traders wishing to hedge related investments. The absolute control of the value and expiry date of the trade, make them perfect for risk management as potential losses and gains are known at the outset with absolute accuracy.
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For traders keen to utilise risk management across their portfolio, binary options could be an extra weapon in their armoury.
Unsure of the tax implications of binary options trading? Read our detailed explanation, written in consultation with HMRC.