Hello traders friends! On the net you can often find disputes “Which is better: Forex or Binary Options?” Did you know that you can create complex positions from Forex orders and options, which generally reduce the risk / insure you in the event of a stop loss triggered? Such positions are called synthetic and today we will learn how to compose them.
Creating a synthetic position from different financial instruments is a very effective way to hedge trading risks. Using the methods of calculating the correlation, we can determine the dependence of some instruments among themselves and, theoretically, create a market-neutral portfolio.
The problem is that it is extremely rare to create an absolutely neutral position within the boundaries of one market. Some addictions are constantly replaced by others and, as a rule, last for a very limited time. That is, creating a synthetic position within one market can only slightly reduce losses, while significantly reducing the amount of potential profit.
By combining the advantages of different markets, in this case Forex and Binary Options, we can create a neutral overall position, the financial result of which will not depend on the direction of price movement of the underlying asset. One of these strategies is the strategy of simultaneously opening a position in the forex market and buying a binary option on the same asset. Since the opportunity to buy a suitable contract on BO does not appear often, the method is not very popular. However, the effectiveness of the method is comparable to arbitrage strategies, greatly increasing the ratio of return to risk.
Constructing a synthetic position
So, a synthetic position is a set of derivative transactions within a single transaction. As a result of which a position appears with the characteristics inherent in the underlying asset.
A simple but not entirely correct example of a synthetic position is a currency pair and a futures. Futures has all the characteristics of a currency pair, it also rises and falls. Correct synthetic positions are much more complicated; futures and options are used to create them. Since futures = synthetic currency pair, we will take currency pair and options.
If we made a purchase of a currency pair, say EURUSD at 1.10, the P&L chart with the x-axis taken would be as follows:
Let’s make certain assumptions: the entry is made after the volatility falls during the American session (after about 21:00 Moscow time), it is planned to hold the position until the opening of the American session the next day. What does it give us? In particular, for the EURUSD pair, in the absence of significant European macroeconomic news, one can count on a hedge within a deviation of 100 points.
Let’s say we have opened a position of 0.1 lot. To hedge a loss of 100 pips, we buy a binary option of the type below equal to the value of the expected maximum deviation ($ 100), paying a 100% premium, with an expiration date that expires at the open of the American session. We get the following position: when the price moves below the level of 1.10, up to the level of 1.09, the profit will decrease (the losses will be covered by the option premium). The task of compensating the loss of the purchased pair has been completed.
A side effect of this construction is that at the time of expiration, if the price is even one tick higher than the level of 1.10, we will get a loss of $ 100.The loss will be the smaller, the higher the price will be by the end of the binary option, becoming zero at point 1.11 …
Using exotic options
The variety of binary options types allows for more balanced synthetic positions. As an example, we will consider an example of a synthetic position consisting of a forex position and a Touch option. First, make sure that the broker has a “Touch” option in the broker’s arsenal . Payment under this contract is carried out upon touching a predetermined level and can go up to 100%. For the test, we will take the less optimistic variant with an 80% profit.
So, when the opportunity arises, we buy the “Touch” contract with the maximum available expiration time. Let’s say the strike price is 50 pips below the current price of the instrument, and the option payout is 80% of the transaction amount. Thus, buying an option worth $ 62.5, in case of a successful outcome, we will receive a profit of $ 50.
Now our task is to open a forex buy position with a stop loss equal to the option’s profit in cash. Considering the stop loss size of 50 pips and the pip value of $ 1, we need to open an order with a volume of 0.1 lot. In this case, when closing a position by stop loss, the loss will be the same $ 50 as the profit on the option contract. That is, we calculate the position size in such a way that the profit on the binary option completely covers the loss on the position.
As a result, we have a binary “Touch” contract with a strike price at the stop loss level of our forex buy position. If the price goes not in our direction, the loss on the Forex position will be covered by the profit on the option, that is, the position will close at breakeven. In order to profit, the price must travel a sufficient distance to cover the value of the option. In this case, the take profit must be at least 63 pips to cover $ 62.5 of the option cost. But, since we want to get a more significant profit, take profit in this case can be set approximately 2 times higher than stop loss, that is, at a distance of 100 points from the opening price.
As a result, there are only two possible outcomes of the transaction – closing by stop loss at breakeven and closing by take profit with a profit of 100 – 62.5 = 37.5 $ (excluding the spread on a forex position). Even if our forecast is not successful, we will not lose anything.
In order not to miss high payouts on options, try to monitor multiple brokers at the same time and enter the market at the first opportunity. Other types of contracts can be used just as well. The main task is to calculate risks in such a way that the total position is neutral to the market, and the profit fully covers trading costs. In any case, the creation of synthetic positions, although it helps to reduce speculative risks, at the same time reduces the rate of return.
Using binary options to create a synthetic position is a fairly effective way to hedge risks.
Thus, before carrying out the “assembly of the structure”, a thorough fundamental and technical analysis of the market is required in order to predict the expected volatility and search for “pivot” levels, according to the principle “where the price will not go”. Thus, this trading system does not free the trader from an in-depth study of the fundamentals of the market and is not a grail, but provides a number of new opportunities and “keys” to profitability.