Because of their all-or-nothing character, binary options offer traders a great way to trade on the direction of an asset or the overall market. And what makes binary options intriguing, besides their straight-forward risk/reward profiles and defined risk, is that they can be used for shorter strategies due to the hourly, daily or weekly expirations of the contracts.
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 expires to a Nadex calculation of the last 25 futures trades just prior to the contract expiration.
If you believed the E-Mini S&P 500 future 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 wouldn’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:
- Underlying E-Mini S&P 500 future currently trading at 1873.75
- Assume bullish view on the E-Mini S&P 500 futures with 1877.75 price target by end of the trading day
- Current time is 1:20pm EST
- Daily contract expires 4:15pm EST (2hr 55 minutes remaining)
Looking at a screenshot from the Nadex platform, there are four different strike prices that have active markets that are below your target price of 1877.75 expiring at the end of the trading day today. 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 (Mar)> 1866 - Cost $97 / Potential profit $3 / Return 3.1% At Expiration
US 500 (Mar)> 1869 - Cost $87 / Potential profit $13 / Return 14.9% At Expiration
US 500 (Mar)> 1872 - Cost $68.50 / Potential profit $31.50 / Return 46.0% At Expiration
US 500 (Mar)> 1875 - Cost $43 / Potential profit $57 / Return 132.6% At Expiration
Assume you decide to buy the US 500 (Mar) > 1872 for $68.50. 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 (Mar) > 1872 contract needs to expire above 1872 in order for you to receive the maximum payout of 100/contract. If the binary expired at the strike of 1872 or below, your maximum loss would be your initial $68.50 cost/contract. In this example, even if the bullish move was not as strong as expected, provided the underlying market remains above 1872 at expiration the contract will settle at 100. Remember that all examples above are not inclusive of exchange fees.
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 your trade.
Binary options may also be used as a vehicle to trade the volatility of the underlying market with limited exposure whereas trading the outright market 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 like you had anticipated and finishes above the strike if you were a BUYER or at or below the strike if you were the SELLER, then the contract is valued at $100 per contract. (Note: when trading the outright market there is no cap to your profit potential but the binary choice offers a comfortable way to participate in the market with limited risk and potential positive return if finishing in the money.)
Low Volatility/Flat Market
If you believe the market will remain flat and trade sideways, you could trade binaries that are in the money. These binaries will have a higher initial cost which is proportionally more expensive 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, so you want time to fly as the contract will be worth $100/contract at expiration. For example, if you paid $80 for the binary position (higher proportional cost out of 100), then your net profit, not inclusive of exchange fees, would be $20 at expiration.
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 (such as EUR/USD and USD/JPY), equity indices (such as US 500, Wall Street 30 and FTSE 100), energy (such as crude oil and natural gas), metals (such as gold and silver), agricultural (such as corn and soybeans) and events (such as jobless claims and Federal Reserve decisions).
Futures, options and swaps involve risk and may not be suitable for all investors.