Strategy of the Week: Hedging Alternatives For Your Binary Option Positions
Binary options trading in its most simple form presents a very unfavorable risk profile for the conservative trader. In general most of the binary options trading platforms offer returns of +60-80% for winning trades and losses of 85-100% for losing trades, not a risk profile we would feel comfortable with over the long haul. That’s why we recommend following up an initial trade with a complementary 2nd trade before expiration. By placing a 2nd trade on the same asset you can swing the risk profile to something a little more manageable.
The most common 2nd trade hedge used in binary options trading is the one in which you first purchase a put or call, then if the stock moves in the correct direction you purchase the opposing put or call to lock in a “money zone”. This is illustrated in the graph below:
As can be seen in the graph, we first bought an Amazon (AMZN) call with a strike of $125 at 11:10 am. With shares of AMZN looking pretty volatile we decided to purchase an AMZN put with a strike of $126 immediately before the “lock-in” time of 11:45. So what does that do to our risk profile? No longer are we constrained by the [+70%, -85%] return profile, we now make 70% with shares of AMZN trading between $125 and $126 and lose 15% with shares of AMZN trading anywhere outside of that range. While the area of “moneyness” seems small, the risk of losing big has been significantly diminished.
The key to profitably trading binary options is knowing when to be aggressive (letting it ride) and knowing when to cut your losses and live to fight another day (place another trade).
In this example we made 2 very big assumptions, 1) the stock moves in the appropriate direction, and 2) the lot size of both trades was equal. In terms of #1, we all know that we are not always going to be able to implement this hedge because at times we are incorrect in picking the correct initial direction. In these instances there are several strategies we can use to alter our risk profile. We will delve into those strategies next week.
As for #2, no one said you needed to trade the same lot size in your complementary trade. Here’s how we approach it. If the stock had moved sufficiently far enough in the money we would in all likelihood let it ride, risking an 85% loss over the 15 minute “lock-in” period. If you don’t feel comfortable risking the 85% loss you can purchase the complementary put or call using a lot size that is smaller than the original lot size. For instance say you initially purchased the AMZN $125 strike call for $100 and it is now 11:44 and shares of AMZN are trading for $126 like in the previous example. Instead of spending $100 to purchase the put hedge, what would spending $50 for the put hedge do to your risk profile? Let’s take a look:
As you can see, your max potential loss has increased in this alternative hedge structure (-33% vs. -15%), though still much lower than the basic 1 trade option max potential loss of -85%. In return for the increase in max potential loss, the area of profitability has widened significantly to include everything above the initial $125 strike. With shares of AMZN trading between $125 and $126 you would make $105 (70%) and with shares trading above $126 your total return would be $28 (19%). There are many ways to alter your risk profile by changing the lot size of the complementary trade. The goal is to find the profile most appropriate for your risk tolerance.
The Week Ahead:
The upcoming week looks fairly light in terms of potential catalysts as much of Wall Street is gearing up for the 3-day July 4th weekend. As a reminder, US markets are closed on MONDAY July 5th in observance of Independence Day. There is, however, an Oppenheimer Consumer Conference being held on Tuesday and Wednesday (6/29-6/30) that could inject some volatility into consumer related names during the week.
One name in particular is Starbucks (SBUX). SBUX is scheduled to present at the Oppenheimer Conference at 10:05 am ET on Wednesday, June 30. Given that this conference is being held at the very end of the quarter, approximately 3 weeks before SBUX’s 3Q earnings announcement, there exists a decent probability that the company will comment on its quarterly results during its presentation. This could present a nice opportunity for binary options traders especially if SBUX does not issue a press release with financial comments prior to its presentation. In any event keep an eye out on SBUX on Wednesday. SBUX binary options can be traded on the EZ Trader binary options trading platform.
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