Hedging is an effective technique for minimizing investment risk. Yet while hedging looks simple enough on paper, practicing it in a live account across your chosen financial assets is much harder and can lead to more losses if wielded carelessly. If you’re a binary options trader looking to expand his/her knowledge and skill set or a complete novice looking for a time-tested and proven strategy for consistently extracting profits from the market, below is a guide to hedging. Keep in mind that it won’t make you a master of hedging overnight, but rather lay out a solid foundation necessary to better understand the technique.
What is Hedging?
In a nutshell, hedging, also known as straddle strategy, is the use of a simultaneous trade on one asset in the opposite direction. The strategy has risk management parameters that allow you to minimize the loss from the initial trade that the hedged position was based from. Hedging is based on the principle that “what goes up, must come down”.
How Does Hedging Work
Basically, you choose a general direction where you expect price to move to in the future. If you are trading binary options, you will have a choice between a Call or Put option. Once you’ve chosen a general direction, you’ll then have to choose an underlying asset you wish to invest in.
At this point, you have a dozen of financial assets you can trade with binary options including gold, currency pairs, and stock indices. Pick an underlying asset that you are familiar with, is liquid, and currently has one-sided opinions from market participants.
For instance, if gold is being viewed as a hot asset to buy over the next few weeks due to an expected increase in demand from Asia, particularly in India where weddings create the need for gold, you can purchase a binary option that grants you the right to buy an asset at a predetermined, lower price.
Example of Hedging
There are hundreds of possible options contracts you can invest money in. A simple example would be putting a $100 call option on gold and hedging it with a $50 put option on the same asset. The profit potential cumulative from both positions will be less since you’ll have to take some loss from either position regardless of where price moves to.
While profit potential is capped with hedging strategies in binary options, it does also effectively cap the risk involved. Using the same example above, if you buy a $100 call option and gold’s price drops, you’re at a $85 hole if you don’t have a hedged position whereas you only lose $50 if you hedge your position with an asset that is negatively correlated with the initial position.
Correlation among asset prices is a natural occurrence and is something you should be aware of if you wish to be a well-rounded trader and investor in the future. If two assets are deemed positively correlated, it means that their prices move parallel to each other. Meanwhile, a negatively correlated pair means that assets move in opposite directions.
Tips for Successful Hedging
You won’t get the very essence of hedging in a manner of days or over a string of few trades. Try your hand on hedging positions using a demo account from Titan Trade first. However, it tends to be challenging to hedge effectively in demo accounts or even in live mini accounts since the range of financial assets you can trade with are limited. Some brokers will withheld the trading of gold and other indices and will only let you trade spot Forex or stocks with binary.
As you become more familiar on how to use hedging strategies in binary options trading, you can then open a standard account with Titan Trade to expand tradable opportunities. Depending on your timing, you may even get promotional bonuses for your account. Advanced traders who use hedging practices don’t limit themselves to correlated positions that have the same expiration dates or at least almost identical ones.
Know When Not to Hedge
Hedging, as mentioned awhile back, is a double-edge sword in that it caps profit potential of your positions. Knowing when not to use it is as important as knowing when to. If, for example, you have a currency pair or stock that’s got a high percentage of being in the money, try to maximize the position by just buying either a Call or a Put option instead of both.
Hedging is one of the quintessential skills to learn as a trader and investor. It’s a nifty tool you can use to minimize capital risk on positions that have a low percentage of being in the money. Complementing it with an intuitive trading platform like that of Titan Trade’s can further increase your profitability over time.
