Investing is not without risk. You can’t expect a high rate of return on your investment if you don’t take any chances. However, this in no way requires you to take on all possible risks associated with a certain investment. You might, instead, use hedging tactics to shift some of the risks to other parties, all for the sake of maximizing your potential reward.
There are a number of hedging strategies for binary options trading against the potential loss of an investment, and some of them are designed specifically for certain types of assets. However, these hedging techniques may be used on a regular basis to lessen the blow of unfavorable events. Three common forms of risk management are discussed below.
1. Purchase of Put Options
One big risk of investing in stocks is that their value might fall. It is possible that the price of a stock may fall to zero, meaning that the investor would lose their entire investment. Stock values of even the most prestigious blue chips may drop by 50% or more over a very short period of time. It’s not common to see this, even among long-standing businesses.
You may decide how much of a loss you’re prepared to take on by acquiring put binary options. By exercising a put option before its expiration, you may sell shares of a company at a predetermined price. If you decide to exercise your put option, the investor who originally sold it to you will pay the agreed-upon price and purchase your shares. In general, you’ll pay more for the option, but your exposure to loss will decrease if the strike price at which the parties agree to swap the shares is higher.
When you think about strategies of hedging for binary options trading, take a well-known technology company with a share price of about $190 as an example. To sell 100 shares at $180 each at any point between now and the middle of July, you may purchase a put option for $1.92 per share, or $192 total. If the price stays over $180 until then, you won’t have to exercise the option and will instead only lose the $192 you put toward it. Still, if the price fell to $170, you could exercise and get $180 instead. In other words, if you paid $1.92 today, your maximum potential loss is $10. If the loss exceeded that amount, you would choose to take the option’s resulting action.
A put option with a strike price of $190, rather than $180, would cost you $5.45 a share if you wanted to completely remove the risk of loss on your stock holding. In case the stock doesn’t drop to the put option’s predetermined strike price, you stand to lose the whole amount you invested in the option.
2. Futures Agreements
In addition, futures contracts provide risk management via hedging. In binary options, the food processing industry would buy futures contracts to protect against the risk of price increases over the same time period, while farmers would sell futures contracts to protect against the risk of prices going down by the time they harvested their crops. Initially, farmers’ markets were the primary target of futures contracts. With the introduction of financial futures, however, futures-based hedging has spread beyond commodities to stocks, bonds, and other financial markets.
3. Financial Backing of a Rival
Making an investment that will move directly against the risk you’re seeking to hedge isn’t always required. Investing in a lot of businesses in one industry might have some hedging benefits. While doing so will mitigate the risk that the company whose stock you now own does not end up winning in that industry, it won’t eliminate the risk that the sector as a whole carries.
Let’s take the example of owning shares in a major American airline. Since both the industry as a whole and that individual airline have certain advantages over their competitors, you think they will prosper. However, you do acknowledge that your stock faces certain risks that are not present in all of its competitors.
Buy shares in the most alluring rival airline if you wish to protect your airline’s position. There might be many effects:
- Both stocks could increase in value if the industry as a whole performs well.
- If it transpires that your concerns about the first airline were unfounded, a gain in the stock price of the second airline may more than makeup for the first one’s losses.
- Both stocks might decline if anything occurs that negatively impacts the overall sector.
- Last but not least, if you choose the second airline incorrectly, it can perform worse than the airline you currently own.
This isn’t a flawless procedure, as you can see. But it provides the benefit of diversifying your portfolio while guarding against a company-specific risk, and many stock investors find that appealing.
Hedge if Necessary
Hedging is neither necessary nor appropriate since, for most investors, the inherent risks of investing constitute an important component of their ability to generate the desired returns. However, if you want to invest in something that is riskier than you are comfortable doing on your own, using a hedging strategy may provide you with the exposure you want at a level of risk you are willing to bear.