Hedging Forex Trades Using Binary Options – EUR/USD Example
A trader with a bias to the upside on the EUR/USD enters a long position with 2 contracts at 1.1015. He sets a stop at 1.1004. This produces a total risk of $210 (excluding commissions). To offset the potential loss he enters a short binary option at 1.1015 with five contracts. The total risk on the binary option side is $256.25 and the profit potential is $243.75 (excluding exchange fees). The binary option expires in one hour.
The goal in using the binary options is to offset any potential losses on the forex EUR/USD trade. In other words, the trader is risking $210 on the forex trade but they are offsetting that loss by capturing the $243.75 profit on the binary option side. Plus the binary option has a full hour till expiration giving the trade time to work in the trader’s favor.
By hedging the position, here are the potential scenarios that can play out:
- EUR/USD forex trade moves up to test the previous high at 1.1030, making profits and the EUR/USD binary option has a full loss, $256.25 excluding exchange fees.
- EUR/USD binary option moves down and realizes a full profit, $243.75 excluding exchange fees, but the trader is stopped out of the EUR/USD forex trade ($210.00 loss, excluding commissions).
Hedging Forex Trades Overcomes Losses
In this case, the EUR/USD forex trade is stopped out and a full loss of $210, excluding commissions is realized. However, the EUR/USD binary option has covered the loss as it has a profit of $221.25 (excluding exchange fees). By allowing the trade to expire, the full profit of $243.75 is realized.
In other words, by hedging forex traders using binary options the trader has turned a losing trade into a breakeven trade and his account has not suffered because the trade went against him.