How to preserve your capital when you’re irresponsibly long using binary options

Or how I learned to stop worrying and love binary options.

The situation

This article looks at how a trader could use short binary options in combination with a long ETH position in spot or futures markets to risk significantly less capital if the trade doesn’t work.

We’ll follow an example case where a trader is long sETH (a synthetic asset that mirrors ETH price) on Kwenta.

For the purposes of this article, only sETH will be addressed but the same basic mechanics could be applied to any situation where a trader goes long on any asset that’s supported by the Synthetix ecosystem.

With Thales, binary options markets can be created for any asset’s price feed supported by Synthetix and Chainlink, including oil, gold, U.S. tech equities, and crypto assets.

Can you feel the synergy?

As the Na’vi teached us: Connected we are stronger.

Meet Bob

Bob is an active Kwenta trader and, as shocking as it might sound, he is irresponsibly long ETH.

Bob’s plan is to become more irresponsibly long ETH by bidding up some sETH.

Bob wants to bet more.

Suppose Bob enters a sETH trade with an entry price of $2,400 for a total position of 100 sETH, that he bought with sUSD.

If the sETH price hits $2,200, Bob would close this sETH position back into sUSD. This is his stop-loss or how much he is willing to lose.

Bob’s trade risks:

Price delta threshold ($200) * units (100) = $20,000 sUSD

This is 8.33% of the initial $240,000 sUSD trade size, assuming no slippage costs and transaction costs.

Bob’s base scenario

Keep that 20.000 figure in mind, we’ll come back to it.

What if…?

With binaries, Bob can alter the payoffs to effectively cut the risk of the trade, and make it “cheaper” to open on the long sETH trade.

That’s right, you heard us.

Both possible scenarios when Bob adds a short binary option (sometimes referred to as a binary put) on top of his long are:

• If ETH goes up, Bob makes money on the sETH trade, minus the cost of the binary options.
• If ETH goes down, Bob makes some money on the binaries trade, losing less in total on the sETH trade than if Bob did not open the short binary options trade.

Let’s examine this more closely.

Math time

For this example case, suppose short ETH binary options are available on Thales for $0.30 each with a $2,400 strike price.

Premiums are just the user's cost to buy the short ETH binary options tokens, so in this case, the premiums for 100 of these specific binary lots will cost $30 sUSD.

The maximum return from 100 sSHORT tokens is $70 sUSD when the premiums are $30 sUSD. We get this by subtracting the $30 sUSD of premiums from the total reward of $100 sUSD.

Now, suppose Bob wants to earn $20,000 on the binaries leg.

The amount of hedgeable exposure is simply the price delta threshold for cutting the trade, $200, times the units, 100 sETH.

This approach means fully offsetting the $20,000 loss on the spot ETH long trade.

By going this path, Bob’s max loss on the trade now just becomes whatever the cost is to hedge $20,000 of spot exposure in the binaries market.

To determine how much binary exposure Bob needs, and therefore the cost of hedging, Bob divides $20,000 sUSD, the total amount to be hedged, by $70 sUSD, the max return on 100 sSHORT tokens.

Here we go.

Exposure to be hedged ($20,000) / max return per binary lot ($70) = 285.71

Bob calculates he needs 285.71 lots of 100 sSHORT tokens with each option having a $2,400 strike price.

Bob’s second scenario trade risks:

Price per binary lot ($30) * number of lots (285.71) = $8,571 sUSD

So the total cost of the hedge is $8,571.43 sUSD.

Ladies and gents, Bob is binary hedged

So instead of risking $20,000 (8.33%) as the downside scenario on the $240,000 initial trade size, Bob’s downside is now limited to $8,571.43 (3.57%) of the initial trade size.

Bob can save up to $11,428.57 by hedging versus just using a stop in this scenario.

Putting it all together

As you can already tell, the premiums on the short binary options will make a huge difference for Bob.

By using short binary options with a strike price roughly the same as the entry price of the long trade, it’s cheaper for Bob to express a long view, because Bob’s stack decreases at a slower pace if the downside case materializes.

For an infinite series of trades, limiting the risk on a trade is a strategy that will replicate very well.

It’s one thing to save a few thousand with binaries in this trade.

It’s another thing that Bob can take more shots overall.

Bob is a shooter, and shooters shoot.

Since Bob used a binary short option in combination with his spot trade, Bob has more ammo to keep shooting.

Do you want to keep shooting too?

Thales is a shooter too.

This strategy might be especially useful for a trade where someone thinks a large move will take place in a relatively short period of time, or if Bob just opened the trade on a Friday afternoon and wants to shoot hoops or play golf over the weekend instead of being in front of the screens.

Closing thoughts

There is still lots of research to be done in how different derivatives instruments can be combined together to offer a wide variety of risk profiles.

Exciting times we are living in.

We will love if you join us for the ride.

• farmwell, Thales co-founder

Disclaimer: Any views in this post are shared for informational purposes and should not be construed as a recommendation or advice to engage in an investment transaction.