It is a called a straddle or hedged trade, and involves taking two binary option positions in the same asset. It has the potential to reduce risk, and double your gain. Here’s how to do it. Assume call and put options that have an 80% payout.
Step 1. Initial Trade
Like any binary options trade, pick an asset and choose your direction. Say the price just broke above a descending trendline indicating the downtrend is over and the price could begin to trend higher. Buy a call option.
If the price continues to run in your favor you don’t need to do anything. Draw a trendline on the new uptrend, and as long as the price stays above that trendline you have nothing else to do because your option will expire in the money.
If the price drops below the upward trendline though, you need to make another trade.
Step 2. Opposing Trade
You are in a call option because the price is advancing in your favor. Then it breaks the trendline indicating a correction or even a potential downtrend is beginning. We now do not know if our call trade will finish in the money. Therefore, when the price breaks below the trendline we buy a put option. This way if the price continues to decline we will profit from the put option.
- If the price continues to advance on the first trade, then there is no second trade. The price ran in your favor and you make $80 on a $100 investment.
- If the first trade goes out of the money immediately and continues to trend against you, you do nothing. It may reverse course and produce a $80 profit, or if finished out of the money you lose the $100.
- If there is a reversal then you take a second trade:
o If the price finishes above the strike price of the call, and below the strike price of the put, you win on both trades, netting $160 ($200 invested)
o If the price finishes below the strike of call you lose $100 on the call. But the price will be below the price of the put, resulting in a $80 profit. So you only lose $20 compared to the $100 risked on the original call trade.
o If the price finished above the strike of the put you lose $100 on the put, but the price will be above the strike of the call, resulting in a $80 profit. So you only lose $20 compared $100 if you had only taken a single put trade.
o It would be a pretty rare event, but is feasibly that you could lose on both trades. The price would need to whipsaw and trade below the call strike at the time of the call expiry and then surge above the strike price of the put at that expiry. This is unlikely to occur, but is possible. To avoid this, make sure there is some distance between the price you buy the call at and the price you buy the put at.
The strategy pays off if the price settles in between your call price and put price. The larger the area between the call and put price the greater the likelihood this scenario occurs. If your call and put are only 5 pips apart in the EUR/USD, that is a very small area for the price to settle in. But if your call and put are 30 pips apart, that provides a wider area for the price to settle in, more likely to result in a profit on both trades.
If your first trade is very far in the money, and is unlikely to expire out of the money, then there is no real reason to take a second trade. You’re better off just taking your 80% on one trade than taking a second trade which goes against the current momentum.
Only take the second trade if looks like the price is reversing–trendlines can be a useful tool here–because this way you hedge your bets. Due to the reversal it is unknown if the first trade will profitable, so by taking a second trade in the opposite direction you reduce your risk if only one finishes in the money, and you double up if they both finish in the money.
Cory Mitchell @corymitc