Hedging strategy is strategy that is always combined with at least one other strategy. Goal of hedging strategy is to minimize investment risk. It can be viewed as kind of insurance policy. But given the fact that markets are not 100% efficient it is not possible to have a perfect hedge.
If you are looking for a big return on your investment this is certainly not the strategy to use. Minimizing risk costs, it actually reduces return on your investment, but on the other hand it increases your chances to finish in the money.
Let’s see closely how hedging strategy works
If you are trading binary options you might find yourself in a situation where you bought option that certain stock will raise, say your target price is 100 dollars. If before expiration period you notice volatility of that same stock you might feel you are going to lose money. Best way to minimize risk is to bet against yourself. This means buying an option that is in the money if price of the stock is under 100 dollars. That way you end up in money either way. There is a catch of course, since risk can never be totally eliminated. You need to pay certain price – volatility premium. When you are trading with binary options you need to pay this new put option some money, in this case this is volatility premium for you. That money gets lost if stock remains above strike price. When hedging binary option your goal is to earn more money on call option than you lose on put option and vice versa.
So, we own binary call option that our stock will end with price more than 100 dollars, so anything below this price is area of loss. Let’s assume we paid this binary option 10 dollars and binary broker pays us 70%. This means if we buy binary put option at strike price 100 dollars, we will end up with 0 profit minus broker fee. This is not great news, but it is certainly better that losing whole investment.
If you own a call option and see that you have been terribly wrong and price is going much lower than expected you can buy put option for much lower strike price which may offer you better return from broker, say 80%. This means you can actually make some money. But in that case you leave a gap in the hedge that is a difference between strike price of call option and strike price of your put option. If upon expiry stock is in that gap you lose money invested in both call and put options.
It works the same way it you own binary put option, only you now need to buy a call option to make a hedge.
To summarize, if you are looking for high return you definitely shouldn’t use this strategy. But if you have made a misjudgment you can save the day with hedging put or hedging call option.
You can read in the more detail about this strategy on investopedia.