Shifting Risk vs. Reward Trading Binary Options
Tommy O’Brien / TFNN
As the inauguration of Donald Trump, the 45th President of The United States of America, is now behind us, we all wonder what the future may hold. Markets have had a tremendous rally since the election. What is most surprising is that for all the volatility that the markets experienced on the actual evening of the election, things have mostly been smooth sailing straight upward since that volatile day. No matter what your political perspective there are uncertainties as to how Donald Trump will govern, and uncertainties of this magnitude do not usually breed such complacency and euphoria among traders.
If you’re anticipating volatile markets in the near future, regardless of whether bullish or bearish, then it’s important to protect your capital from fast and unexpected moves across a variety of worldwide markets. Binary options on the Nadex Exchange offer a variety of defined risk trading opportunities. Developing a trading plan that includes planned exit levels for taking profits as well as minimizing losses prior to expiration can significantly increase your potential for profitability, while decreasing your overall risk.
When you first begin trading binary options, because of their short term nature and defined risk, many traders employ a strategy of planning to hold them until expiration. Instead of using the defined risk as an excuse to not need to exit the trade prior to expiration, let’s look at the idea of using mental stop levels and possible targets as an exit strategy to decrease your overall risk and increase potential profitability.
Here we see a chart of the indicative index, which is based on the CME E-mini S&P 500 Index March Futures, as of the previous day, Thursday January 19th at 4:15 p.m. ET. Note along the right axis are some of the weekly binary options available on the Nadex Exchange. Weekly binary options on the S&P 500 expire at 4:15 p.m. ET on Friday, leaving exactly 24 hours until expiration.
Whether you’re bullish or bearish, there are always opportunities on both sides of the market when trading binary options. Let’s first take a look at some potential bullish strategies in the S&P 500. If you wanted a high probability trade then one binary option you could purchase is the >2,255.50 at $72.25. Because this binary option is in-the-money, your cost is higher so you would be risking $72.25 for a potential profit of $27.75 hoping it expired for full settlement value of $100 per contract. If you were to take this trade then you would be risking $2.60 for every $1 in potential profit. Granted, the underlying S&P 500 March Futures contract is more than 6 full points above your chosen strike price but there is still 24 hours where the market could possibly move below the 2255.50 level resulting in the position being worthless at expiration. This is still a substantial amount of money to risk resulting in the need to be correct about 3 out of 4 times to be profitable if held until expiration.
Instead of using a strategy of holding your binary option until expiration, what if you used a mental stop to exit the trade if it moved against you to a certain degree prior to expiration? If you initiated this trade thinking that the market would not trade at or below 2,255.50 prior to expiration, then let’s examine the strategy of exiting the trade if that scenario arrives instead of just holding until expiration.
Remember when the underlying market is trading at or near the strike, the binary should be priced close to $50.00 assuming there is still time remaining prior to expiration. So you could use a mental stop of around $47.00 to exit the trade if the underlying index traded back down to the strike price, there by cutting your planned risk dramatically. Binary options are easy to analyze the risk vs. reward when held until expiration, yet many times that may not be the most profitable strategy depending on your market bias and expectation. If you chose the 2,255.50 strike price because you felt the market would not trade at or below that price prior to expiration, then your trading plan has already gone wrong if it crosses that point any time prior to Friday’s close. Why would you then keep the trade open at a 50/50 probability of success if your original trading plan has already gone wrong?
If you planned to exit the trade at around $47.00 in case the underlying S&P 500 March Futures contract traded back to your strike price of 2,255.50, then you would be cutting your planned potential losses to only $25.25. If you held the binary option until expiration then you would have been risking the entire $72.25 for $27.75 in potential profits, but by using a planned exit of $47.00 if the underlying contract trades back to your strike price you’re now only planning to risk $25.25 for the same $27.75 in potential profits. Now, instead of risking $2.60 for every potential $1 in profit you’ve dramatically shifted your trading plan to risking $0.91 for every $1 in potential profit. Instead of needing to be correct 3 out of 4 times to be profitable, you’ve now shifted the risk vs. reward of your trade to only needing to be correct 50% of the time.
This strategy can be employed similarly when purchasing out-of-the-money binary options. This time let’s say you decided to purchase the higher strike binary option at >2,267.50. You could risk $34.25 for a potential profit of $65.75 if it expired in-the-money as of 4:15 p.m. ET Friday. You’d be risking about $0.52 for every $1 of potential profit. While this is a much better initial risk vs. reward set up than the previous example, it’s also important to realize that this trade has a lower probability of success if held to expiration, which is why you are afforded a much cheaper entry price.
Now, instead of planning to try and achieve the full value of $100 by holding the binary option until expiration let’s take a look at the strategy of planning on taking profits prior to Friday’s close. If the underlying index were to trade up to your strike price of 2,267.50 any time prior to expiration then the bid and offer would be priced right around $50.00. Assuming about a $6 spread between the bid and offer, this could potentially allow you to exit this position at $47.00. If you held this >2,267.50 binary option until expiration you would have been risking $34.25 for a maximum profit of $65.75, but when exiting the trade at the planned price of $47.00 you’re now risking that same $34.25 for only $12.75 in profit. While you would cut your planned potential profit down to only $12.75, you would also simultaneously increase your probability of success dramatically because of the frequency of times the market will allow you to exit the position at a profit as compared with if held until expiration.
Instead of needing the underlying S&P March Futures contract to close above 2,267.50 as of Friday’s close to be profitable, your new trading plan would only need the index to touch that level at any point in the 24 hours remaining until expiration to take profits. Simply trading up to the 2,267.50 price point within a 24 hour period has a much higher likelihood than the index closing over that level at the binary expiration.
Looking at the bearish side of the trade there are, of course, similar opportunities available. You can always choose to sell a binary option if your market expectation is negative. Regardless of whether you are selling a binary options that is above or below the current index pricing, using planned exit levels for either cutting losses or taking an early profit prior to expiration can allow you to shift the risk vs. reward on your trade sets in a dramatic fashion.
Don’t get trapped into the mentality of thinking that because binary options provide a simple risk vs. reward set-up that they should be held until expiration. When you first begin trading binary options many investors have a tendency to use their defined risk as an excuse to not use a stop or possible profit target. Binary options are like any other trading vehicle and should be treated accordingly. In many instances it may make sense to exit the trade prior to expiration in order to either cut losses or lock in profits, depending on your market expectation.
Binary options tend to lend themselves to traders thinking that holding them to expiration is an easy way to trade the markets with defined risk, which is true. You should keep in mind that by employing mental stops and potential profit targets to exit the position prior to expiration could actually have the potential to increase your overall profitability dramatically depending on your market bias.
Note: Exchange fees excluded for calculations.
Nadex Risk Disclaimer
- Trading on Nadex involves financial risk and may not be appropriate for all investors. The information presented here is for information and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Any trading decisions that you make are solely your responsibility. Past performance is not necessarily indicative of future results. Nadex instruments include forex, stock indexes, commodity futures, and economic events.
- Nadex binary options and spreads can be volatile and investors risk losing their investment on any given transaction. However, the limited-risk nature of Nadex contracts ensures investors cannot lose more than the cost to enter the transaction. Nadex is subject to U.S. regulatory oversight by the CFTC.