They have been available on the New York Stock Exchange (NYSE) only since 2016 but owing to their fixed all-or-nothing payout, binary options (also called digital options) are becoming popular among traders and are gaining some interest from individual investors, particularly as a tool for hedging their positions in stocks.

Compared to the traditional plain vanilla put-call options that have a variable payout, binary options have fixed amount payouts, which makes the potential risk and return clear up front.

That may make them seem simple but make no mistake: binary options are an exotic financial instrument and are not for the faint of heart. The payout really is all or nothing.

Quick Primer to Binary Options

True to the literal meaning of the word “binary,” binary options provide only two possible payoffs: a fixed amount ($100) or nothing ($0). To purchase a binary option, an option buyer pays the option seller an amount called the option premium.

Binary options have other standard parameters similar to those of standard options: a strike price, an expiry date, and an underlying stock or index on which the binary option is defined.

Buying the binary option allows the buyer a chance to receive either $100 or nothing, depending on a condition being met. For exchange-traded binary options defined on stocks, the condition is linked to the settlement value of the underlying crossing over the strike price on the expiry date.

For example, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from the option seller, a net profit of $100 minus the option premium paid. If the condition is not met, the option seller pays nothing and keeps the option premium as profit.

Binary call options guarantee $100 to the buyer if the underlying settles above the strike price, while a binary put option guarantees $100 to the buyer if the underlying settles below the strike price.

In either case, the seller benefits if the condition is not met, keeping the option premium as profit.

With binary options available on common stocks trading on exchanges including the NYSE, stock positions can be efficiently hedged to mitigate loss-making scenarios.

How to Hedge a Long Stock Position Using Binary Options

• Assume stock ABC, Inc. is trading at $35 per share. An investor purchases 300 shares for a total of $10,500 with a stop-loss limit of $30. That means the investor’s maximum loss will be $5 per share.

This long position in stock will incur losses if the stock price declines. But a binary put option will provide a $100 payout if its price declines. Marrying the two can provide the required hedge.

A binary put option can be used to meet the hedging requirements of the above-mentioned long stock position.

Assume that a binary put option with a strike price of $35 is available for $0.25. How many such binary put options should the investor purchase to hedge the long stock position? Here is a step-by-step calculation:

• Level of protection required = maximum possible acceptable loss per share = $35 – $30 = $5.
• Total dollar value of hedging = level of protection * number of shares = $5 * 300 = $1,500.
• A standard binary option lot has a size of 100 contracts. One needs to purchase at least 100 binary option contracts. Since a binary put option is available at $0.25, total cost needed for buying one lot = $0.25 * 100 contracts = $25. This is also called the option premium amount.
• Maximum profit available from binary put = maximum option payout – option premium = $100 – $25 = $75.
• Number of binary put options required = total hedge required/maximum profit per contract = $1,500/$75 = 20.
• Total cost for hedging = $0.25 * 20 * 100 = $500.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

Where,

In the absence of the hedge provided by the binary put option, the investor could have suffered a loss of up to $1,500 at the stop-loss level of $30 (as indicated in column (b)).

By hedging with an extra $500 in binary put options, the loss is limited to $0 (as indicated in column (e)) at the underlying price level of $30.

A Consideration for Real-Life Trading Scenarios

• Hedging comes at a cost. It provides protection from losses but also reduces the net profit if the stock is profitable. This is demonstrated by the difference between values in column (b) and column (e), which show (profit from stock) and (profit from stock + binary put option) respectively. Above the stock profitability scenario (underlying price going above $35), column (b) values are higher than those in column (e).
• Hedging also needs a pre-determined stop-loss level. It is needed to calculate the required binary put option quantity for hedging.
• In the example, the investor must square off the positions if the pre-determined stop-loss level of $30 is hit. If not, the losses will continue to increase as demonstrated by row 1 and 2 in the table above, corresponding to underlying price levels of $25 and $20.
• Brokerage charges must be taken into account, as they can significantly impact the hedged position, profit, and loss.

How to Hedge a Short Stock Position Using Binary Options

For this example, let’s say that the investor is short on 400 shares of a stock with a selling price of $70. The investor wants to hedge up to $80, meaning the maximum loss would be ($70 – $80) * 400 = $4,000.

This means:

• The level of protection required is equal to the maximum possible acceptable loss per share, which is $80 – $70 = $10.
• The total dollar value of hedging is equal to the level of protection * number of shares, which is $10 * 400 = $4,000.
• Assuming a binary call option with a strike price of $70 is available at an option premium of $0.14, the cost to buy one lot of 100 contracts will be $14.
• The maximum profit available from binary call = maximum option payout – option premium = $100 – $14 = $86.
• Number of binary call options required is equal to the total hedge required/maximum profit per contract, which is $4,000/$86 = 46.511, rounding down to 46 lots.
• The total cost for hedging therefore is $0.14 * 46 * 100 = $644.

Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:

Where,

In the absence of hedging, this investor would have suffered a loss of $4,000 at the stop-loss level of $80 (indicated by column (b) value).

By hedging, using binary call options, the loss is limited to $44 (indicated by column (e) value).

Ideally, this loss should have been zero, as was observed in the example of binary put hedge example in the first section. This $44 loss is attributed to the rounding off of the required number of binary call options. The calculated value was 46.511 lots and was truncated to 46 lots.

The Bottom Line

Plain vanilla call and put options as well as futures have traditionally been used as hedging tools. Binary options add one more tool for the investor seeking to hedge potential losses on heavily-traded stocks.

The examples above, one for hedging long stock positions and one for hedging short positions, illustrate the potential effectiveness of using binary options.

With so many varied instruments to hedge, traders and investors should select the one that suits their needs best at the lowest cost.