Contrarian Binary Option Trades with the VIX under $10

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Contrarian Binary Option Trades with the VIX under $10

Author: Tommy O’Brien / TFNN

 

The VIX Index, sometime referred to as the fear index or the fear gauge, is a representation of expectation of market volatility in the near future. Using the prices of puts and calls in the near term on the S&P 500, the VIX is able to use the implied volatility of those options to provide an indication of the expected volatility of the market. The VIX has been trading at historically low levels recently, and just made a new 52 week low as of this morning on May 8that $9.72. With a VIX at extremely low levels, this means that correlating options in the market will have very little premium priced in. If you’re a trader that expects volatility in either direction then this is a great time to capitalize on opportunities present in the market.

Here is a chart of the VIX on May 8th that shows the 52 week low of $9.72 that it just traded to.
 VIX Chart

Source: TD Ameritrade

When trading any vehicle it’s important to understand what you’re paying for. As many traders begin experimenting with trading options, one of the most important components becomes the premium that you are paying or accepting as part of that trade. If you are bullish or bearish, or even market neutral, many times you can be correct with what direction you expect the market to move but whether or not you are profitable will be determined by what kind of premium you paid or received when initiating the trade

A good rule to remember when it comes to the VIX is ‘the rule of 16’. (Rule 16 for more in depth explaining the VIX and the rule of 16). When the VIX is trading at $16 then that means that the market is generally pricing in a 1% move in the S&P 500 every 1 out of 3 days, and this is in either direction. With the market relatively calm so far this year, it’s easy to see why the VIX has spent most of its time between $10 and $11. With the VIX hitting a low of $9.72 this morning we’re approaching all-time low levels of premium being priced into near term S&P options. This is something that all traders should be aware of at all times, especially if you trade any type of options.

If the VIX were to spike back up to $16 anytime soon then you would see a correlation of the premium being priced into S&P options to offset the expected volatility in the market. With the VIX at extremely low levels this presents the potential opportunity to pay small amounts of premiums in the market, and if correct on anticipated market movements in the future then the rewards could be vast.

Let’s take a look at some of the S&P binary options available on the NADEX Exchange today to illustrate the types of premiums present on a daily and weekly basis with the VIX under $10.

Here is a chart of the Nadex US 500 June Index, which is based on CME® E-mini S&P 500 Index® Futures, as about Noon on May 8th. Along the right hand axis are some of the weekly binary strikes available that expire at 4:15 p.m. ET Friday.
 Nadex US 500 June Index

Source: NADEX

The Index is trading at 2,392.25 at the time of the chart, and you can see that there are opportunities to the upside and downside with varying risk vs. reward set ups. If you were to choose to buy the >2,420.50 strike price you would be paying $10.50 for a profit potential of $89.50 if it expired in-the-money as of Friday’s close. While this particular binary option is currently about 28 points away from being profitable, that is not an outlandish amount of movement to expect when risking $1 for every $8.52 in potential profit for a 1.18% move in the index by Friday’s close.

Taking a look at the downside, if you were to sell the 2,372.50 strike price at $81.25 you would be risking $18.75 (Your short at the 81.25 trade price thus the risk is from the trade price up to 100) for a potential profit of $81.25. In this case you would be risking $1 for every $4.33 in potential profit expecting the S&P to decline to at or below 2,372.50 by Friday’s close. Again, while the market is currently 19.75 points away from the strike price of 2,372.50, that is not an unrealistic movement by Friday’s close when you’re able to risk only $1 to make $4.33 expecting the underlying Index to move 0.82% to the downside by Friday’s close.

Now let’s take a look at the market on an even shorter term time frame. Here is the same Nadex US 500 June Index, which is based on CME® E-mini S&P 500 Index® Futures, as about Noon on May 8th. In this chart below the binary option strike prices along the right axis represent daily binary options expiring at 4:15 p.m. ET the same day, which leaves about 4 hours and 21 minutes.
 Nadex US 500 June Index

Source: NADEX

If you’re expecting the market to rise on this particular day then one possible trade could be to buy the >2,400 binary option at $9.00 with a maximum profit of $91.00 if it expired in the money by 4:15 p.m. ET.  This strike price is currently 7.75 points out-of-the-money, which represents a 0.32% move in the index, but that could be an attractive set-up depending on your market expectation for the day considering you’re getting better than 10 to 1 odds on your money.

And similarly to the downside you might consider choosing to sell the >2,385.0 strike price for $89.75, which would have $10.25 of risk and $89.75 of potential profit. This bearish binary option is 7.25 points out-of-the-money, but again at almost a 10 to 1 risk vs. reward this could be an attractive set-up to many traders depending on their market expectations.

As you become more familiar with binary options on the Nadex Exchange you can choose to take things to the next level if you want with multi-leg trades to capitalize on moves in either direction.

Let’s stay on the daily chart of the Nadex US 500 Index, and let’s now take a look at purchasing both binary options from our previous example. Instead of choosing one direction, you can trade volatility in either direction if you’re expecting fast moves in the market up or down before the day’s close.

If you bought the >2,400.00 binary option at $9 and simultaneously sold the >2,385 binary option at $89.75 then you would have a combined risk of $19.25 for both of these contracts. You would now be expecting the market to close either above 2,400 or at or below 2,385 prior to the day’s expiration. If either binary option expired in the money you would receive the full value of $100.00 at expiration. Even when adding up the cost of both binary options you would only be risking $1 for every $4.19 of potential profit if one of them expired in-the-money.

So with the VIX approaching historically low levels, and there is very little premium being priced into the market for expected volatility, it may be a time to consider taking those contrarian views with binary options.

Note: Exchange fees not included in 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 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. 


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