where do binary options dealers hedge their risk?

[Sig]

Well, they are pricing a digital by pricing a tight call spread, but don't always hedge it. When I was running an exotics book, I would only hedge really large digital risk (e.g. 100m in size) and smaller stuff I would just throw into the book (it is actually booked as a call spread) and delta-hedge.


Oh, nobody exactly replicates each and every tiny digital, that would be silly. The market maker trades them and hedges delta, if the call spread width is wide enough, you will statistically make money. However, if digital risk on any strike is too high, we can always offset it in vanilla options, not necessarily of the same maturity.

Sorry to drag up an old thread, but I'm stumped on how you would offset a binary position with a vanilla of a different maturity. For example, I'm a market maker and I have a daily binary that expires at 4:00 on Monday, and the nearest vanilla expires at 4:00 on Fri. A customer buys a whole bunch of 5000 strike calls Mon AM at when the instrument is at 5000 so the price is around $50. I do a hedging spread on the vanilla, say 5005/5000, which also is going to be around $50. The instrument closes at 5000.1 on Mon. I have the pay out the entire value of the binary, but my "hedge" is still right at 50 since there are 4 days to go on the vanilla, so I really hedged nothing! What am I missing here?

 

[southall]

Sorry to drag up an old thread, but I'm stumped on how you would offset a binary position with a vanilla of a different maturity. For example, I'm a market maker and I have a daily binary that expires at 4:00 on Monday, and the nearest vanilla expires at 4:00 on Fri. A customer buys a whole bunch of 5000 strike calls Mon AM at when the instrument is at 5000 so the price is around $50. I do a hedging spread on the vanilla, say 5005/5000, which also is going to be around $50. The instrument closes at 5000.1 on Mon. I have the pay out the entire value of the binary, but my "hedge" is still right at 50 since there are 4 days to go on the vanilla, so I really hedged nothing! What am I missing here?

They dont hedge. They take the other side of your trade. The binary is always too expensive if you want to buy it and always too cheap if you want to sell it (ie very wide spread). They could make a mistake in pricing but this is very rare these days.

 

[nomoremondays]

They dont hedge. They take the other side of your trade. The binary is always too expensive if you want to buy it and always too cheap if you want to sell it (ie very wide spread). They could make a mistake in pricing but this is very rare these days.

Not just for retail. Even on the institutional side it would be the same, especially for short dates. No matter how much skew or jump risk you would pump into the structure you could barely recover what the banks were charging you!

As an aside to #11, and I realize it's only a thought experiment, but the same day digital would not price the same at $50 as a weekly spread, no matter how thin. You would be charged for instantaneous jump through the nose.

 

[galvinlee888]

They dont hedge. They take the other side of your trade. The binary is always too expensive if you want to buy it and always too cheap if you want to sell it (ie very wide spread). They could make a mistake in pricing but this is very rare these days.

True. Any real traders with options experience will understand this clearly. Volatility is the only thing matter in options trading and not directional bet. Pricing based on Volatility is everything.

The sad thing is those brokers (mainly bucket shops) are targeting the disadvantaged groups that always below capital, as those 5k trader are mostly directional traders (most of them are losers that trade based on BS chart settings such as RSI, oscillator and etc ) which have no clue on what they are doing.

I can't stop laughing when i saw one snake oil salesman, aka binary mentor that try to convince his followers to use some BS TA (support / resistance and etc) to enter a binary in predefined time. When i asked him the statistically proof that he has edge on his approach, he stared at me and speechless, and i know at the moment that he has no clue what is the statistics test. This go to classic believe- those can trade profitable will not teach, those teach can't trade.

 

[777]

Risk?

They situationally widen the spread from bad to worse.