Hedging Binary Option with Spot FX Trade — Case Study

Back in 2013, inspired by a poll on the future of the EUR/USD currency pair, we decided to conduct a small case study on combining a traditional FX trade with a binary no-touch trade to hedge some of the risks. That experiment is described below.

No-touch trade opportunity

No-touch is a kind of a binary option contract that turns profitable if a given level is not hit (there was no touch) during a given time period. If we take the EUR/USD 1.3710 level as an example and the year's end as the period (82 days from October 10 when the experiment was held), buying a no-touch binary option would be a winning trade if the price ended that period without reaching 1.3710 level, and a losing one if it didn't reach that price level during those 82 days.

Usually, we do not trade binary options as the pricing is too high in my opinion. What I mean is that if you add prices of two opposite direction options (e.g., touch and no-touch for the same price level), you get $105 for a $100 contract, which means 5% commission built into the binary contract's price. That is much higher than people pay to open spot Forex positions — 2–3 pips of spread on the course of the hundreds of pips of potential profit normally result in less than 1% commission.

This case is rather different. First, there is no 100% certainty that EUR/USD will not reach 1.3710 level by the end of 2013, but that level looks like a significant resistance for the currency pair. So, the current price on no-touch option for that level and period looks like a bargain. You can get a $32.06 quote for $100 contract from Binary.com. Of course, you may try any other binary options broker and probably get even a lower offer (if you manage to find a binary broker with no-touch options with flexible strike price). Let's round it up to $33 for the sake of easier calculations. $100 — $33 = $67 profit. With $33 total risk, that is 1:2 risk-to-reward ratio. As you can see the deal itself looks attractive enough for a binary option. The screenshot below shows the $10,000 contract example:

Protecting against risks

No hedge

You may decide to skip the hedging part completely and risk your full stake to get $2 for each $1 risked in case EUR/USD does not reach 1.3710 during the remaining 82 days before December 31, 2013. Here are the possible outcomes and your profit/loss for this case (here and on, we will use $100 contract as an example):

1. EUR/USD does not touch 1.3710 — you win and get a $67 profit.

2. EUR/USD touches 1.3710 — you lose and book a $33 loss.

Conclusion: simple, straightforward way to bet on an event. The option strike price (yellow line) and the major support level (red line) are marked, but no hedging is visible on the chart below:

Simple spot hedge without stop-loss

If losing $33 in case of a EUR/USD price hitting 1.3710 sounds too dangerous, you may decide to hedge your binary contract with a specially sized spot Forex transaction. Since we are aiming to compensate for the case when EUR/USD goes up to 1.3710, we can easily say that we need a buy order with 1.3710 take-profit level. The position size is determined based on the distance from current rate to TP and the amount we want to hedge. With 1.3532 current rate, that is 178 pips and $33, respectively. One pip should be worth $0.1854 ($33 / 178), which is achieved with a position of 1,854 currency units or roughly 0.19 of a minilot. So, what outcomes could we get with this ultra-simple hedge?

1. EUR/USD reaches 1.3710 during the period — binary options contract loses $33, spot position earns $33, net result: $0.

2. EUR/USD ends the period above 1.3532 (hedge position entry level) and below 1.3710 without touching it — binary option contract yields $67 profit, spot position earns $0-$33 (18.54 cents per pip), net result: $67-$100 profit.

3. EUR/USD ends the period below 1.3532 but above 1.3354 without touching 1.3710 level — binary option contract still yields $67 profit, but the spot position loses up to $67 (18.54 cents per pip), net result: $0–67 profit.

4. EUR/USD ends the period below 1.3354 without touching 1.3710 level — binary option contract still yields $67 profit; spot position becomes a major loser with uncapped potential for loss (18.54 cents per pip), net result: $0-$∞ loss.

Conclusion: simple hedging with a single position and a single calculation routine — the position size based on distance between current rate and option's strike price. The perfect outcome here is when the price remains between 1.3710 (the option's strike) and the spot position's open level. The only losing scenario is EUR/USD finishing far below the spot entry level, which still gets partially compensated by the binary option win. It can be recommended when you are confident that the market will be range-bound. Hedging position example is shown below — as you can see, it has TP but not SL:

Simple spot hedge with stop-loss

If you get a panic attack from thinking about unlimited loss that is possible in the previous scenario, you might want to lock your potential drawdown with a stop-loss. You start the same as with the previous hedge model — take-profit, position size based on TP distance, and option value. To prevent bigger losses, it is now necessary to set stop-loss for the spot EUR/USD position. You can use whatever level you are comfortable with — a volatility-based stop-loss, support level, trend line, Fibo, chart pattern, etc. We will use the 1.3417 support level in this example. You may decide to use a bigger SL to give your position more wiggle room or go with a tighter one for stricter risk control. The possible outcomes differ a lot compared to the previous no-SL hedge model:

1. EUR/USD reaches 1.3710 during the period before hitting SL — the binary options contract loses $33, spot position earns $33, net result: $0.

2. EUR/USD ends the period above 1.3532 (hedge position entry level) and below 1.3710, touching neither it nor SL — the binary option contract yields $67 profit, spot position earns $0-$33 (18.54 cents per pip), net result: $67-$100 profit.

3. EUR/USD ends the period below 1.3532 but above 1.3417 (SL) without touching the 1.3710 level — the binary option contract still yields $67 profit, but the spot position loses up to $21.32 (18.54 cents per pip), net result: $45.68-$67 profit.

4. EUR/USD ends the period without reaching 1.3710, but having triggered SL — the binary option contract still yields $67 profit; spot position ends with $21.32 loss (18.54 cents per pip), net result: $45.68 profit.

5. EUR/USD reaches SL first, then proceeds to 1.3710 — the binary option contract results in $33 loss; spot position ends up with $21.32 loss (18.54 cents per pip), net result: $54.32 loss.

Conclusion: as you can see, there are five distinct outcomes now. All but two lead to significant profit (compared to the initial risk on binary option). One leads to a zero gain. Only one outcome is really bad — when the price goes down to spot position's SL first and then proceeds to a new yearly high. The loss there is more than double of the initial risk. How probable is such an outcome greatly depends on the chosen SL and the EUR/USD volatility during the period. The stop-loss is added to the previous example:

Conditional spot hedge with stop-loss

If you really hate losing big amounts, you can consider adding a small twist to the SL hedge model — a conditional exit out of the binary option. The initial settings are the same as with the simple SL hedge model — TP, SL, position sizing, and all. But now, since you can sell your no-touch option anytime (at least with Binary.com), you may decide to do so when the stop-loss is hit. What difference does that make to those five outcomes? Now, there are only four of them:

1–3. The first three outcomes are the same as in the previous model.

4. EUR/USD ends the period without reaching 1.3710, but having triggered SL. The spot position results in $21.32 loss (18.54 cents per pip), but the binary option sale yields some profit. As the current EUR/USD price is now below your option entry price, its value can be anywhere between $33 and $100, which means $0-$67 profit. Net result: between $21.32 loss and $45.68 profit.

Conclusion: the new twist removes the previous worst outcome of $54.32 loss and adds an outcome with a rather undefined loss/profit situation. In fact, the farther is your SL from your spot entry price and the less time left till the binary option's expiry, the higher is the option's selling price. There is one disadvantage with this hedging method — you have to sell the option contract manually unless your binary trading platform offers conditional sale on certain underlying price. It may be a difficult thing to do both physically (e.g., you are asleep when your SL is hit) and emotionally (e.g., you suddenly decide against selling your option).

Which hedge model to choose?

It totally depends on two factors: your forecast for the EUR/USD behavior and your risk tolerance:

• If you just believe that EUR/USD will not rise much before the year's end and you are comfortable taking a full-risk trade at it, then there is no need to resort to hedging at all.
• If you believe that EUR/USD has some potential for rising and you take risk lightly, you can use the simple spot hedge model without stop-loss. However, if you want to limit your spot exposure risks, then the simple stop-loss model is probably a better choice.
• If you are afraid of EUR/USD jumping wildly down then up and want as little risk as possible, then the conditional spot hedge model with stop-loss is your friend.

The actual trade

We will not be trading this position on a live account, but instead we entered a virtual option trade and a demo spot trade. We have used a $10,000 contract instead of a $100 one, so that hedging position could be entered with an exact sizing using hundredths of a standard lot. Our exact no-touch option price was $3,205.51 with EUR/USD at 1.3532 at that moment. The distance to TP was 178 pips, which resulted in the following gain per pip: $3,205.51 / 178 = $18.01, hence a position size of 1.80 standard lots. Unfortunately, we entered it incorrectly as 1.81, which will result in a somewhat bigger loss in case EUR/USD hits the stop-loss or ends the year below our entry. Speaking of which, the actual market price was 1.3533, so our wrong position size fits it almost perfectly ($3,205.51 / 177 = $18.11 per pip or 1.81 standard lot position size). As you can see there are some serious execution risks to be taken into consideration.

The MetaTrader screenshots that you see above are of our actual position. We will use the simple hedging model with stop-loss, which means that we will not sell our binary option manually if our spot SL gets hit.

A note on swaps

82 days is a rather long period to hold an open foreign exchange position. Normally, your spot EUR/USD hedge position will incur swap payments for every day it is left overnight unless you are trading via Islamic-friendly broker with a no-interest account. Since the current (as of 2013) interest rates are higher for the euro (0.5% vs. 0–0.25%), you would expect to be earning interest on your EUR/USD long position. It could add to your net profit or minimize your losses in case of an unpleasant outcome.

In reality, not all brokers calculate their rollover interest logically or fairly. We have opened our hedge position on a demo account from Alpari, and they charge $0.70 per standard lot to hold a long position overnight (so, that is -$1.27 per day for our case study example). They would be us paying $0.30 per standard lot for holding a short EUR/USD position. The good thing is that our loss on swaps will be rather small compared to the overall balance change caused by this hedged binary option trade. If we scale it down to $100 contract, it would be only $1.04 additional loss for 82 days, and the position could be closed by the stop-loss much earlier than that.

On the other hand, our live account broker (Exness) offers a $1.073 positive swap on long EUR/USD deals and a $2.505 negative swap on short EUR/USD deals. If we decided to conduct this hedging case study with real money, we would be getting extra $1.94/day just for holding our hedge position open.

As you can see, swaps are worth paying close attention to when setting up a hedge position. You could be either earning some small additional income or losing slightly from them. In our opinion, the former is a preferred choice in nearly all cases. By the way, did you notice an arbitrage opportunity that exists between Alpari and Exness swaps? But that is a completely different story.

Case study results

So today, on October 22, 2013, the EUR/USD currency pair has finally surpassed its previous maximum for 2013 and thus has finalized our case study research. The no-touch binary option is now valued at $0, which means a $3,205.51 loss for us (fortunately, in demo money). Our spot hedge position resulted in $3,203.70 direct profit and a $12.70 loss on swaps. The resulting total loss is $14.51, which is only 0.5% of the original risk. Despite the fact that we haven't gained anything through this trade, we believe that we may call it a successful hedging trade, which proved several points stated in this case study.

The resulting EUR/USD chart:

Disclaimer: The links to Binary.com used above are affiliate links. Here is a direct link to their website if you prefer: https://www.binary.com/. You may also try to find better trading conditions with other binary brokers.

PS: You might be interested in this hedging calculator if you are serious about this trading technique.

If you have some questions about the proposed ways of hedging a binary trading position using a spot trade, you can discuss it on our Forex forum.