Managing-Risk

One of the most important concepts that successful investors understand and practice is the idea of risk management. Defined as minimizing potential losses while maintaining the largest gains possible, there are many different ways in which it can be done. In fact, one risk management strategy can be entirely separate and even contrary to others, depending the type of security one has invested in. Because binary options are still relatively new, risk management strategies for them are still being developed by clever traders and financial engineers. Below are two well developed strategies that almost any trader can incorporate into their overall strategy to limit losses while preserving profit potential.

Hedging a Call

Using two different binary options contracts (one put and one call), a trader can both increase their profit potential and reduce their maximum loss given a certain set of conditions. It’s started by buying a binary option call on any given underlying asset. If the underlying’s price moves to “in the money” territory, the trader can then buy a put option at that higher price, in a move that’s referred to as a “full hedge”.

By doing this, the trader creates a spread (all prices between the call’s strike and the put’s strike) where both options expire in the money, doubling their return. In the event that the underlying asset’s price moves too far, they are almost assured that one of the two options they placed will expire “in the money”, which greatly cuts their maximum loss as a percentage of the total investment.

The Forex Hedge

Many Forex traders use a risk management strategy that incorporates binary options to give them a sort of “cushion” to work with in a given Forex position. Say a trader goes long on EUR/USD, and they grow concerned that volatility might erase their gains thus far. Here, a binary put option could be placed where the “breakout point” (the level where Forex traders exit their position) of a given trade is. Because this breakout point is often tested, many Forex traders exit their position too early and miss out on profits.

By placing a binary put option at that level, a trader can use the payout as an extra cushion to allow their Forex position to push the breakout level and potentially rise again without exiting early. While this put option will ideally expire out-of-the-money and reduce their gains, making the hedge in proper relative proportions can add a considerable amount of security to a Forex trade.

One Response to “Binary Options Risk Management”

  1. avatar
    jlkutughk - December 12th, 2011 at 8:25 PM

    Kelly…

    I just saw this really good post today….

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