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Hedging strategy

Even everyday life, not only trading in the financial markets, requires protection from possible risks or losses. People buy medical or mortgage insurance to protect themselves from potential unpredicted expenses related to diseases or weather disasters. This protection is nothing but hedge although it is not related to the financial markets at all. When it comes to the binary options trading, investors should keep a sequence of steps and measures in order to act accordingly in case of unexpected losses happen. Such an algorithm is called a Hedging Strategy, and it is a must-have option for every trader.

What is Hedging?


Financial markets are unpredictable in terms of changing trading conditions rapidly. Sometimes a fundamental event could shift traders and investors sentiment dramatically with a sudden reversal in the price action of many asset classes. One of the latest examples of such an event was noticed when terrorists suddenly attacked Saudi Arabia’s oil refinery facility, damaging the plant which has more than 5% of the global supply capacity. As a result, oil prices soared more than 12% in one single day on September 16, 2019. That was the largest daily spike of oil prices in 30 years. If a trader was buying put options before the event happened, he could experience a tough period of losses, which weren’t predictable by any type of analysis. Therefore, any binary options trader has to have a plan B, an algorithm of appropriate actions to minimize potential losses if something goes wrong in the market. Such an algorithm is exactly the Hedge Strategy.

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Types of Hedging risks


Importers and exporters. Around the globe might they suffer from rapid shifts in currency exchange rates. If a company’s business is located in one country but oriented to export to another country, exchange rates might have a significant impact on the overall profit at the end of the day. Thus, some exporters or importers might be interested to buy a long-term CALL or PUT option for a particular currency pair to hedge themselves from possible unwished spikes or sudden swings of the rate, which might lead to unexpected losses.

Trading binary options. Imagine a trader has a strong prediction that EUR/USD should keep the downtrend as the single European currency is extremely weak amid fundamentals and economic reports in the region. However, the U.S. dollar might be vulnerable to sell-offs due to geopolitical or monetary policy risks, which appear from time to time. Therefore, holding a put option for EUR/USD might be hedged by buying a put option for the USD/CHF currency pair which reflects the risk aversion flows across the board. A similar case might appear when trading binary options for gold and equities at the same time. During a strong uptrend in stock indices, it would be reasonable to buy CALL options for single shares. However, if markets reverse and capital flows are headed towards safe-havens, the price of gold gives a chance to buy CALL options for the yellow metal a the same time withholding calls for equities.

Hedging stocks on Different Timeframes


One more technique became popular among binary options traders. Imagine you bought a 24-hours call option for GBP/USD counting on a positive outcome of Brexit negotiations between the United Kingdom and European Union. However, by the end of the day, you see that negotiations are getting stuck in the middle of nowhere, politicians do not show any willingness to arrange a deal, and GBP/USD went far below the entry-level. Thus, the chances for a sudden huge spike of the exchange rate to get the previously bought a call option in the money are minimal. But you could buy a 4-hours put option for an amount large enough to protect your initial deal and cover those losses. Hedging binary options on different timeframes allow traders to maximize the efficiency of the trading system as avoiding losses is not less important than making profitable forecasts.

How does Hedging Work?


The number of ways of using the binary options hedge strategy is almost unlimited as the wide variety of underlying assets and a large number of different expiration times gives an endless ratio of combinations. Before entering the market, traders should assess what are the chances of a negative outcome and identify a certain list of actions to do in case if the market conditions change and the forecast goes wrong.

The Hedge Binary Option Strategy aimed to protect binary options from potential losses is related to risk management. For example, buying a CALL option on top of the market, even if the recent uptrend was sustainable and robust, increases chances of a negative outcome as the retracement might happen. Thus, a trader should decide when is the deadline to act and what steps he or she has to perform in order to protect the account balance from subsidence. At the same time, traders should avoid putting all eggs in one basket and do not open deals with too large volume compared to the overall account balance. This technique would leave a room to manoeuvre, giving a chance to improve the situation thanks to hedging.

Tip to Use the Hedging Strategy for Options Trading:
You don’t always have to hedge with the same amount.

Hedging example


The technical analysis pointed to a strong support level for the S&P 500 benchmark on the daily chart below. The index charted a long downside shadow of the daily candlestick on September 27, underlining a sustainable demand for call options at the level of 2950.0 points. After two days in green, the rate was indicating a bullish continuation rather than the bearish reversal as the overall long-term uptrend was still in play. Considering those factors, a trader had bought a call option for S&P 500 with 24-hours expiration time on October 1.

Hedging strategy

Initially, the market was in favour of the trader and the rate was gradually gaining strength. However, the 4-hours intraday chart below shows a sudden reversal in the trend’s direction influenced by fundamental factors. As a result of volatile action, the S&P 500 benchmark breached the horizontal static support at around 2960.0 points with the four-hourly close, forcing the trader to open a hedging position as rates were too far from the entry point and profitable zone. Thus, the trader bought a 4-hours put option for the index, which was in the money by the end of the expiration time. The binary options hedge strategy helped him to avoid losses from the previous 24-hours call deal and to keep the efficiency of the trading system at a high level.

Hedging strategy

Conclusions


Any trader is keen on seeking ways to protect the trading account from potential losses, and the binary options hedging strategy is a must-have option in the set of tools aimed to optimize the decision-making process. Market conditions might change in a blink of an eye and a previous analysis might not work properly due to fluctuations in traders’ sentiment. Therefore, any binary options trader should have a certain set of rules and steps to protect the trading account and hedge it from different types of risks related to the financial conditions. Traders could hedge from losses by adding another asset in their portfolio, which might reflect possible changes. At the same time, traders could open simultaneous deals with both directions and different timeframes when a trend is not in favour of the initial decision, paring losses. In general, the hedging algorithm has to play the role of a plan B in case if something goes wrong during trading.


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