How To Hedge Stock Positions Using Binary Options

Binary option trading had been only available on lesser-known exchanges like Nadex and Cantor, and on a few overseas brokerage firms. However, recently, the New York Stock Exchange (NYSE) introduced binary options trading on its platform, which will help binary options become more popular. Owing to their fixed amount all-or-nothing payout, binary options are already very popular among traders. Compared to the tradition plain vanilla put-call options that have variable payout, binary options have fixed amount payouts, which help traders be aware about the possible risk-return profile upfront.

The fixed amount payout structure with upfront information about maximum possible loss and maximum possible profit enables the binary options to be efficiently used for hedging. This article discusses how binary options can be used to hedge a long stock position and a short stock position. (For more, see: Hedging Basics: What Is A Hedge?)

Quick Primer To Binary Options

Going by the literal meaning of the word ‘binary,’ binary options provide only two possible payoffs: a fixed amount ($100) or nothing ($0). To purchase a binary option, an option buyer pays the option seller an amount called the option premium. Binary options have other standard parameters similar to a standard option: a strike price, an expiry date, and an underlying stock or index on which the binary option is defined.

Buying the binary option allows the buyer a chance to receive either $100 or nothing, depending on a condition being met. For exchange-traded binary options defined on stocks, the condition is linked to the settlement value of the underlying crossing over the strike price on the expiry date. For example, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from option seller, taking his net profit to ($100 – option premium paid). If the condition is not met, the option seller pays nothing and keeps the option premium as his profit.

Binary call options guarantee $100 to the buyer if the underlying settles above the strike price, while binary put option guarantees $100 to the buyer if the underlying settles below the strike price. In either case, the seller benefits if the condition is not met, as he gets to keep the option premium as his profit. (For more, see: A Guide To Trading Binary Options In The U.S.)

With binary options available on common stocks trading on exchanges like the NYSE, stock positions can be efficiently hedged to mitigate loss-making scenarios.

Hedge Long Stock Position Using Binary Options

Assume stock ABC, Inc. is trading at $35 per share and Ami purchases 300 shares totaling to $10,500. She sets the stop-loss limit to $30—meaning she is willing to take a maximum loss of $5 per share. The moment the stock price falls to $30, Ami will book her losses and get out of the trade. In essence, she is looking for assurance that:

• Her maximum loss remains limited to $5 per share, or $5 * 300 shares = $1,500 in total.
• Her pre-determined stop-loss level is $30.

Her long position in stock will incur losses when the stock price declines. A binary put option provides a $100 payout on declines. Marrying the two can provide the required hedge. A binary put option can be used to meet the hedging requirements of the above-mentioned long stock position.

Assume that a binary put option with strike price of $35 is available for $0.25. How many such binary put options should Ami purchase to hedge her long stock position till $30? Here is a step-by-step calculation:

• Level of protection required = maximum possible acceptable loss per share = $35 - $30 = $5.
• Total dollar value of hedging = level of protection * number of shares = $5 * 300 = $1,500.
• A standard binary option lot has a size of 100 contracts. One needs to purchase at least 100 binary option contracts. Since a binary put option is available at $0.25, total cost needed for buying one lot = $0.25 * 100 contracts = $25. This is also called the option premium amount.
• Maximum profit available from binary put = maximum option payout – option premium = $100 - $25 = $75.
• Number of binary put options required = total hedge required/maximum profit per contract = $1,500/$75 = 20.
• Total cost for hedging = $0.25 * 20 * 100 = $500.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

Where,

In the absence of the hedge from binary put option, Ami would have suffered a loss of up to $1,500 at her desired stop-loss level of $30 (as indicated in column (b)).

With the hedging taken from binary put option, her loss gets limited to $0 (as indicated in column (e)) at the underlying price level of $30.

By paying extra $500 for hedging with binary put options, Ami was successful in achieving the desired hedged position.

Consideration for real-life trading scenarios:

• Hedging comes at a cost ($500). It provides the protection for loss-making scenarios, but also reduces the net profit in case the stock position is profitable. This is demonstrated by difference between values in column (b) and column (e), which show (profit from stock) and (profit from stock + binary put option) respectively. Above the stock profitability scenario (underlying price going above $35), column (b) values are higher than those in column (e).
• Hedging also needs a pre-determined stop-loss level ($30 in this case). It is needed to calculate the required binary put option quantity for hedging
• Ami is required to square off the positions if the pre-determined stop-loss level ($30) is hit. If she does not do it, her losses will continue to increase as demonstrated by row 1 and 2 in the table above, corresponding to underlying price levels of $25 and $20.
• Brokerage charges also need to be taken into account, as they can significantly impact the hedged position, profit and loss.
• Depending upon price and quantity, it is possible that one may not get a perfect round figure for number of binary options to buy. It may need to be truncated or rounded-off, which can impact the hedging position (see example in next section).

Hedge Short Stock Position Using Binary Options

Assume Molly is short on a stock with a sell price of $70 and quantity of 400. She wants to hedge until $80, meaning the maximum loss she wants is ($70 - $80) * 400 = $4,000.

• Level of protection required = maximum possible acceptable loss per share = $80 - $70 = $10.
• Total dollar value of hedging = level of protection * number of shares = $10 * 400 = $4,000.
• Assuming a binary call option with strike price of $70 is available at an option premium $0.14, the cost to buy one lot of 100 contracts will be $14.
• Maximum profit available from binary call = maximum option payout – option premium = $100 - $14 = $86.
• Number of binary call options required = total hedge required/maximum profit per contract = $4,000/$86 = 46.511, truncating to 46 lots.
• Total cost for hedging = $0.14 * 46 * 100 = $644.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

Where,

In the absence of hedging, Molly would have suffered a loss of $4,000 at her desired stop-loss level of $80 (indicated by column (b) value).

With the hedging, using binary call options, her loss gets limited to only $44 (indicated by column (e) value). Ideally, this loss should have been zero, as was observed in the example of binary put hedge example in the first section. This $44 loss is attributed to the rounding off of required number of binary call options. The calculated value was 46.511 lots, and was truncated to 46 lots.

The Bottom Line

Plain vanilla call and put options, and futures have traditionally been used as hedging tools. The introduction of binary options on heavily-traded stocks on large exchanges like NYSE will make hedging easier for individuals, giving them more instruments. The examples above, one for hedging long and one for short stock positions, indicate the effectiveness of using binary options for hedging. With so many varied instruments to hedge, traders and investors, should select the one that suits their needs best at the lowest cost.