Contents:Protective Put is a type of hedging from different kinds of risks in binary options trading. Whether a trader is holding a long position for single shares or stock indices, whether a real-money account is willing to hedge from currency exchange risk, whether a binary options trader needs to defend current open deal - all those goals are available to achieve with the Protective Put Strategy.
This method applies to any expiration time and underlying asset. The structure of the binary options type of trading in financial markets suggests a profitable deal even if the price change is minimal. Therefore, combinations of different purposes as wells as different chart periods allow traders to defend account balances from possible subsidence amid wrong trading decisions or sudden changes in the market conditions or investors’ sentiment. Besides the risk mentioned above, there is always a chance of an unexpected headline or unpredictable, event both macroeconomic or geopolitics, which could shift the focus of the financial markets, influencing a sharp change in prices. Protective Put is a solution to avoid possible losses in that kind of scenarios.
What is a Protective Put?
Protective Put is usually bought at the same time holding a CALL option or a long position of security with physical supply. The aim is to generate an additional profit from potentially losing the trading position in order to compensate possible losses and hedge from sudden shifts in the market price. The strike price of the defensive deal is usually equal or close to the entry price of the previous position. Expiry times might differ though depending on the exact purpose of the second entry.
If an equity trader is holding a long deal for a single share, and he is not confident that the position will give him a decent amount of profit due to some unpredictable factors, he is keen on protecting his account balance. The best way to do so is to buy a Protective Put option for the same security but with a shorter expiry time. In this way, the account balance is protected wherever the price of the underlying asset goes. If it edges higher than the previous deal (long-term protective call) is giving a profit equal to the protective position. Otherwise, if the price goes down, the second position compensates the previous loss.
Types of Protective Put
Depending on the kind of risk to hedge from and an exact trading strategy there are several types of approaches:
- Mixed types of trading
- This method is related to the situation described above. Whether an investor prefers trading physical shares on the stock exchange or margin trading in the foreign exchange market, he would be interested to buy a Protective Put option at some point.
- Mixed expiry period
- This type of hedging is related to binary options trading in the financial markets. In case of a long-term protective call option is not giving the expected level of profitability, a binary options trader can buy a put option for the same underlying asset but with a different expiration time.
- Economic reports
- The economic calendar is full of important events, which could influence the price action in both short- and long-term perspective. Thus, having a defensive trading position for the case if a report missed the market expectations is not a bad idea.
How a Protective Put works
Imagine a business related to export-import operations. It’s understood that in order to maintain a highly competitive level, an importer or exporter would be forced to keep the price range of his goods at an approximately stable level in the country he deals with. But what would happen is the currency exchange rate suddenly plunges or soars, impacting the overall profitability level of the business? Rising prices would not help too much as the competition could be lost. Thus, buying a Protective Puts is the only reasonable hedge from this kind of risk.
Another example is related to foreign exchange traders. Assume a huge financial institution or a pension fund invested a decent amount into a long position for the U.S. dollar versus Japanese yen. However, sudden macroeconomic events and geopolitical tensions forced FX traders to run into safe-have assets. As a result, the USD/JPY currency pair declines sharply.
In this case, the financial institution can use the Protective Put option Strategy, compensating the possible loss of the initial investment.
The same purpose of the Protective Put could be used when trading binary options. Imagine an oil trader is keen on the long-term trading strategy and he prefers to hold a portfolio of call options with large expiration time instead of frequently opening and closing a huge number of deals on a daily basis. Abruptly, the U.S. Crude Oil inventories report comes in with a huge spike in the main figure. The oil market starts panicking and selling the black gold as the supply could seriously overcome the demand. In this case, the trader does not exclude the long-term positioning from the portfolio but buys a short-term Protective Put.
Best time frames to use Protective Put
The Protective Put approach can be used on any timeframe available from your binary options broker. The main idea is that the Protective Put has to have a shorter expiration time than the main investment. So, for example, if a trader bought a protective call option for gold with a 24-hours expiration time, and the price went far below the entry-level, then he would be interested to buy a Protective Put option with the expiration of 6-minutes and less. The main goal is to keep an eye on current market momentum, and if the bearish action is strong, then it would be reasonable to buy the put option.
Another advantage of the defensive strategy is that traders can buy several put options with short-term expiry in a row. This method is called a trading cycle. If the price action is gradual and the downtrend is sustainable, then it’s worth considering several put options with ultra-short-term expiration periods such as 5-minutes or even 60 seconds. Thanks to the selling pressure, the overall number of deals in the money will be much higher than the number of green candlesticks. Thus, the profit would not only cover the previous wrong decision but also get the account balance into positive territory.
Calculating of Protective Put
The trading volume or the size of the deal to open with hedging purposes depends on two factors:
- Amount of the previous deal (long position or call option);
- Payout of the underlying asset.
In case of binary options trader had a call option for EUR/USD with an entry-amount of $100, and the payout is rated at 85%.
Protective Put calculator will look as follows:
$100 / 0.85 = $117.65
The amount can also be enlarged depending on the market conditions and the broker’s requirements. Lowering the figure would not cover possible losses from the previous deal.
If you like this strategy, you might also be interested in this Binary Snipers Strategy
Example of using Protective Put strategy
The market is full of events that might change the recent trends direction. Sometimes it’s related to simple volatility as prices always move like waves. Sometimes it’s happening due to some unpredictable shifts in market conditions. However, the examples below show how a binary options trader can avoid possible losses related to different factors.
Brent Crude Oil charted a long upside candlestick on August 13 as traders were rushing to buy call options after the global demand report showed a sudden spike in oil consumption. The price breached significant psychological and technical resistance of $60 per barrel, and all of the technical indicators were pointing to a bullish continuation. Another call option was bought by a trader on August 14 daily open with an entry price of $61.02 per barrel as the screenshot below shows.
However, the intraday price action had an entirely opposite nature. Traders were interested to squeeze shorts, supply-demand concerns eased, the OPEC organization reported a strong level of oil production and output. All of those reasons caused a bearish reversal on the four-hourly chart (see the screenshot below). After a long red candlestick, the trader bought a Protective Put with the expiration time of 4 hours. As a result, he avoided losses from the previous deal.
The price of gold was in the long-term uptrend, according to the daily chart below. On August 25, the yellow metal closed the day at the highest level in six years. A trader bought a call option on the next day open at $1526.74 per ounce with a 24-hours expiration time, counting on the bullish continuation.
However, after the price of gold reached a strong resistance level of $1555.00 per ounce, traders suddenly reversed the price action as profit-taking orders were triggered. By the end of August 26, the trader had doubts that the previous deal would turn into cash as the price was hovering at around the same level. Thus he bought a Protective Put with 60-minutes expiry just to secure the non-risk mode. As a result, both options were profitable and the trader doubled up his profit without any risk.
Protective Put strategy is a multi-purpose hedging method allowing traders in the financial markets hedging from any kind of risk. Even though investors might prefer different types of trading, defensive positions could not only protect account balance from unwished outcomes but also increase the overall profitability. Different combinations of approaches depending on the type of risk-event allow the strategy to add flexibility to the trading system. Besides, mixing several expiration times in order to hedge the account balance is one of the most simple methods to compensate for potential losses. All of those advantages make the Protective Put a must-have instrument in the set of traders tools.