Initially, the hedging strategy was used by Forex traders and it allowed traders to sell or purchase currency pairs at a specified time in the future for a set or fixed price. The benefit was that traders were not committed to this fixed price yet it served as a predefined exit point. The hedging strategy was then applied to binary options trading and many traders use this strategy in their daily trading without even being aware of it. The benefit of the hedging strategy is that it is simple to execute and so anyone can use it in order to minimize the risk of trading. Many traders also apply this strategy when the market is very volatile and the added benefit is that it can be applied to any asset class such as indices, stocks, commodities and currency pairs.

In its basic form, the hedging strategy or hedging, requires a trader to place two opposite trades, Call and Put, so that if one trade ends unsuccessfully or ‘out of the money’, the other trade is likely to end successfully or ‘in the money’. By purchasing two opposite trades, the Put option will be hedged by the Call option while the Call option will be hedged by the Put option. Sounds simple enough, right?

The Hedging Strategy in Action

Let us look at an example to show how to use the hedging strategy. For the purpose of this example, let us use Facebook shares. These shares are trading at $51 and the VXmarkets platform is offering a trade in Facebook shares with an expiry time of 30 minutes. You decide to do a little market research and can see that the market is quite bullish and that Facebook is launching a new feature. Based on this and other analytical charts, you predict that the price of Facebook shares will rise in the short term and so you will make a Call option trade with a 30 minute expiry time. After a few minutes, you notice the price of Facebook shares is rising and so your trade is currently ‘in the money’ but you also notice that the asset price is very volatile and fluctuating. You are afraid that the Facebook share price will decline and your Call option trade will end ‘out of the money’ and so you decide to open a Put option trade with the same expiry time in order to protect your loss. You now have two opposite trades for the same asset, Facebook shares, with the same expiry time.

There are a few possible outcomes based on purchasing both trade options. The one scenario is that the Facebook shares rise to $55 and your Call option trade will end ‘in the money’ while your Put option trade will end ‘out of the money’. Or, the Facebook share price rises to $55 at the expiry of the 30 minute Call option trade which will then end ‘in the money’ and the share price then drops to $49 and so the Put option trade will also end ‘in the money’. The third scenario is that the share price of Facebook drops to $48 and your Call option trade will expire ‘out of the money’ while the Put option trade will end ‘in the money’. The final scenario is that the price of Facebook shares remains at $51 and both the Call and Put option trades will end ‘at the money’ and the trader will get back their original investment amounts.

Benefits of the Hedging Strategy

You might be wondering how the hedging strategy reduces the risk of trading so let us view this strategy in numbers. If a trader purchases a Call option trade for $100 and the trade ends ‘out of the money’, the trader will lose $100. If the trader, however, purchases a Call and a Put option trade for $100 each, the total investment amount is $200. If the one trade ends ‘in the money’, the trader will be paid out 80% so the total profit on the one trade will be $180 and the loss on the other is $100. This means that the total loss will be $20 as opposed to the $100 loss if the trader only purchased one trade option. In this way, the hedging strategy reduces the risk of trading.

Conclusion

The hedging strategy is an effective and simple way to reduce the risks involved in trading binary options. Since this strategy is so easy to implement, even a novice trader can use it and it is also very simple to execute the hedging strategy on the trading platform. The added benefit is that with the hedging strategy, a trader can also take advantage of volatile fluctuations in asset prices while minimizing their risks.