Birthday Wishes Boss
Randall Liss has 20+ years of experience trading, as well as 11+ years providing educational and consulting services on option theory.
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Binary options pay out depending on the outcome of a simple "yes or no" proposition, making them clear-cut yet flexible trading tools.
Key Takeaways
- Binaries can be used to make directional bets, but also can be used to profit from sideways markets or to trade volatility.
- Because they are all-or-nothing binary options bear little resemblance to traditional options, featuring different payouts, fees, and risks, as well as a unique liquidity structure and investment process.
- For our examples, we will use the commonly traded S&P 500 index binary options traded on the Nadex platform.
Introduction Birthday Wishes Boss
For a purely directional trade, let’s use the US 500 Binary as an example. This is a contract Nadex offers which is a derivative of the E-Mini S&P 500 future and uses a Nadex calculation of the last 25 futures trades just prior to contract expiration.
If you believed the E-Mini S&P 500 futures contract was headed for new highs after trading through a resistance level, you could buy the US 500 Binary to capitalize on your market opinion.
On the other hand, if you believed the E-mini S&P 500 future won’t reach a certain price level target; you could sell the binary strikes above your price target in the exact same binary option.
For this directional trade example, let’s assume the following:
- E-Mini S&P 500 futures contract trading at 2756.75
- Bullish view on the E-Mini S&P 500 futures with 2770.00 price target by end of the trading day
- Current time is 10:50pm EST
- Daily contract expires 4:15pm EST
Looking at a screenshot from the Nadex platform, there are four different strike prices that have active markets below your target price of 2770.00 expiring at the end of the trading day. Each strike will have its own unique risk/reward profile relative to the underlying market price and binary strike price.
Buying the Binary Option at the Offer Price:
- US 500 (Sep)> 2760 - Cost $45 / Potential profit $55 / Return 122% At Expiration
- US 500 (Sep)> 2763 - Cost $34 / Potential profit $66 / Return 194% At Expiration
- US 500 (Sep)> 2766 - Cost $27.75 / Potential profit $72.25 / Return 260% At Expiration
- US 500 (Sep)> 2769 - Cost $21.50 / Potential profit $78.50 / Return 365% At Expiration
Assume you decide to buy the US 500 (Sep) > 2763 for $34.00. All binary option contracts settle at $0 or $100 at expiration and it is important to remember that a binary option needs to be only .01% in the money for it to expire at 100. So essentially, your US 500 (Sep) > 2763 contract needs to expire above 2763 in order for you to receive the maximum payout of $100/contract. If the binary expired at the strike of 2762.00 or below, your maximum loss would be your initial $34.00 cost/contract. (Note: these examples don't include exchange fees).
In this example, the contract will settle at $100 even if the bullish move was not as strong as expected, provided the underlying market remains above 2763 at expiration Another important point to remember is that you are in no way committed to hold your position until expiration when trading binary options. You can take your profit or cut losses early at any time before expiration if you would like to exit the trade.
Trading Volatility
Binary options may also be used as a vehicle to trade the volatility of the underlying market with limited exposure when trading the underlying market directly in volatile conditions can be quite risky.
With binary options, you can buy or sell market direction using strikes which are out of the money, i.e. cheaper initial cost. If the underlying market goes higher as anticipated and finishes above the strike if you were a BUYER, or at or below the strike if you were the SELLER, the contract is valued at $100. There is no cap to profit potential when trading the underlying market but the binary choice offers a comfortable way to participate with limited risk and potential positive return.
Low Volatility/Flat Market
If you believe the market will remain flat and trade sideways, you can trade binaries that are in the money. These binaries will have a higher initial cost and a lower return due to the capped payout structure at expiration. As long as the market remains flat, the binary is already in the money and you want no changes because the contract will be worth $100 at expiration.
For example, if you paid $80 for the binary position, your net profit not inclusive of exchange fees would be $20 at expiration.
The Bottom Line
Traders can take advantage of binary options through numerous strategies on the Nadex exchange. Nadex is a fully regulated US exchange offering contracts on currency pairs, equity indices, energy, metals, agricultural and events. These strategies involve risk and may not be suitable for all investors.