How to Improve Your Trading Success with Binary Options
By Tommy O’Brien
Binary options by definition have only two possible outcomes, they either expire in the money for the full settlement payout value or expire worthless. At expiration the binary settlement value is always $100 per contract which either goes to the binary buyer or seller. The binary pricing trades between 0 to 100 reflecting the market’s assessment of the particular underlying market price finishing higher or lower than the strike upon expiration.
Generally a binary quoted well above 50 reflects that the underlying market price is trading above the strike and that the binary buyer has the immediate trade advantage. A binary quoted well below 50 reflects that the underlying market price is trading below the strike and that the binary seller has the immediate advantage.
When trading binary options, the first approach of many traders is to take that attitude to “go for it all” probably because of the very nature of option, it’s the all or none settlement at expiration for all the marbles.
When trading binaries when using in-the-money options, you’ll often be risking multiples of your maximum profit for any particular trade if held until expiration. Many traders think of binary options as only a trade with two possible outcomes, you either are correct and it closes in your favor above or below the strike price as anticipated – or it doesn’t and you lose your entire initial cost when entering the trade.
When looking to trade binary options that are in-the-money you should consider the binary price levels where you want to cut your trade exposure to potential losses. The clearer your understanding of the exact risk vs. reward of any potential trade, the greater your ability to correctly calculate your potential profitability.
The example below is the weekly Wall St 30 binary option chain which is based on the CBOT E-mini Dow Futures. The snapshot was taken on a recent Thursday afternoon around the market close, with 24 hours left until expiration. As you can see the indicative index is well above the binary strike circled for these weekly binary options reflecting a higher proportional price out of the $100 settlement payout.
The Indicative index price represents a continuous calculation process of what the Nadex expiration valuation would be at this moment in time. The calculation uses the last 25 futures trades as a sample set of the E-mini Dow Futures which at this time is at 16,275.40.
Many traders initially are more comfortable with the idea of risking $20 for a max profit of $80, yet are not as comfortable when it comes to the other side of that trade. Keep in mind this comfort of lower risk is a reflection of the lower probability of a successful outcome on the trade. Risking $80 to make a max profit of $20 means that you need to be correct 4 out of 5 times in order to just break even. However you are paying for the initial higher probability for a successful outcome. It’s a tradeoff.
What many traders do not realize is that by combining an exit strategy using price levels of the underlying price or binary price with in-the-money binary options that you can dramatically shift your risk vs. reward ratios to levels that most traders would be comfortable. By understanding these types of risk vs. reward calculations can help you become a more successful trader when trading binary options.
With 24 hours until expiration, let’s assume you’re expecting the market, the E-mini Dow futures to trade flat to grind higher until Fridays close. One choice could be to buy any of the binary options with strike prices below the current market using the Wall Street 30 binary.
If you purchased the Wall Street 30 binary > 16075 at 81, you would be to giving yourself 200 points of insurance or downside premium protection where the binary is trading in the money but as you can see, you are paying for that initial advantage.
The counter is you would be risking the $81 per contract (Exchange fees excluded) which is your initial cost to make a max profit of $19 if the E-mini Dow 30 futures expires on Friday at 4:15pm ET anywhere above 16,075. Remember if you were to make this trade and plan to hold it until expiration then you would need to be correct more than 4 out of 5 times to be profitable.
Another option Instead of holding the binary option position 24 hours until expiration, you could choose to add a mental exit strategy at a price level where your trade position dramatically shifts your risk vs. reward scenario.
If you chose the 16,075 binary strike because your trading plan did not anticipate the E-mini Dow Futures falling 200 points at any time before Friday’s close, then you could choose to cover this trade as an exit strategy if the underlying index reaches that level at any point prior to expiration. Remember your risking everything, the entire $81 per contract if the underlying price is trading below the strike at expiration.
As a general rule with binary options is if the underlying market price is trading at or near the binary strike then the binary pricing should be around a trade price of 50. So if the E-mini Dow futures were to retrace back down to the 16,075 price level, then the binary option would be trading around 50. For this example we will factor a $6 spread for the bid- offer of the binary quote to be a 47 bid at 53 offer.
So instead of risking all $81 per contract on this trade, you could use an underlying price level as your signal to exit the position if the E-mini Dow futures were to retrace back to the strike price level.
Using this type of strategy, assuming you exit your binary position around 47, you essentially decrease your planned risk to $34 with your max profit remaining at $19. This new risk vs. reward ratio changes your ratio to risking only $1.79 for every $1 in profit, as opposed to risking $4.26 for every $1 in profit assuming your intentions are always holding binary positions until expiration.
Realize that using the strategy of holding in the money binary positions until expiration you could finish in the money 4 out of 5 times and still lose money. However when using defined price levels as an exit strategy, you can finish in the money only 2 out of 3 times and be profitable using the numbers in this example.
While binary options have only two possible outcomes, it’s important to realize the trading opportunities that are present leading up to expiration. By managing your trade risk in combination with in-the-money binary options you can dramatically shift the risk vs. reward profile of your trades to hopefully improve your trading consistency.
Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.