Hedging Strategy refers to a range of strategies that can be used to minimize risks in very volatile market conditions. Hedging often refers to combining of two or more trading strategies which can minimize risks. We discussed a type of Hedging in Chapter 6 of Basic Course. The strategy was called Risk Reversal but that is not the only strategy that can be applied. There are other Hedging strategies that can be used too.
The basic concept of Hedging Strategy is to place two opposite trades so that if one loses, the other trade – if it wins – will reduce the loss amount. Let us take a look at a quick example of Hedging.
Let us assume that you are trading in EUR/USD currency pair in a highly volatile market. You go for a technical analysis and find out that the underlying asset has been ranging for some time. You work with Pivot Points and support and resistance to find that a possible price break out is around the corner and the market will take a Bearish trend or the value of EUR/USD will fall. So, you take the following steps:
- You place a Put Option trade at a certain strike price.
- You set the expiry time of 15 minutes.
- You invest $200 with the contract that if you win, you will win 70% and if you lose, you will lose 90% of your investment.
There are two outcomes of this trade:
- You win and you make $140 (70% profit).
- You lose and you lose $180 (90% loss).
Now because of the market volatility, you see that as the trade closes towards its expiry, instead of a Bearish breakout, the price moves upward with a Bullish trend. If you do nothing and you lose the trade, you will lose $180. This is where you will Hedge and reduce the risk. To Hedge, you will now buy a Call Option with following conditions:
- You keep the strike price same as the previous Put option trade.
- You keep the same expiry time of 15 minutes. It is the same 15 minutes as before so that the Call Option expires at the same time when the Put Option expires.
- You invest $200.
Now, if your Put Option loses and Call Option wins, you will lose $180 in Put Option but win $140 in Call Option. So, your total effective loss will be your Profit from Call Option minus your Loss from Put Option. This is $(140-180) = – $40. Similarly, if your Put Option wins and Call Option loses, you will win $140 in Put Option but lose $180 in Call Option. So, your total effective loss will be your Profit from Put Option minus your Loss from Call Option. This is $(140-180) = – $40. In either cases, you will lose just $40 instead of $180. So, you actually limit your risks by combining different strategies.
Long Term Options Trading
When a single trade takes place over a long period of time, it is called long term trade. When you use long term trades in binary options market, it is called long term binary options trading. A long term trade can have a trading period of anything from 1 hour to 1 month or more. Traders who opt for long term binary options trading are far more concerned about long term price trends instead of short term price fluctuations. For long term trading in binary options, a trader must put equal importance on fundamental analysis as on technical analysis because prediction of price trends for a long term can be very risky. So, using Hedging strategies for long term trades is the best thing to do because it can absorb any unexpected volatility and minimize the risk.,