How to Trade Volatility Using Binary Options - Sponsored by Nadex

By Randall Liss AAA

Binary options are similar to classic options with some slight nuances but the components used for the option’s pricing are the same; underlying market, strike (K), volatility and time. While these components are all important and have their influences to the pricing, we are going to focus on the short-term opportunities with trading volatility using binary options.

The pricing of a binary option is actually the market’s consensus that there will be a particular outcome at a specific time. For example, it could be that the S&P 500 will be above 1650 at 2pm the next day.

If the binary strike is at or around the actual underlying market price, in this case the E-mini S&P 500 futures contract, then the binary pricing will be around 50. The binary at expiration is worth $100 per contract so given this scenario neither binary party (buyer or seller) has an immediate advantage so it’s priced around half of the contract value.

Volatility

There are two types of volatility, historical and implied. Historical is simply how the price of the underlying asset has changed in the past during a certain time frame. Implied volatility is how the market currently expects the asset to perform in the future.

Historical volatility does have a strong tendency to revert to the mean so a prudent trader always is aware of what the historical volatility has been and what the implied volatility is predicting the moves will be.

Selling Volatility/Range Trading

If you believe the underlying market will be stagnant and/or stay within a certain range then using binaries can be useful to capitalize on your insight. The binary strikes that you would consider are ITM binaries which would mean your initial cost is a larger portion of the maximum $100 expiration payout. (You are paying for the immediate advantage)

Using this strategy, you can either buy or sell the binary strike outright which is in the money (ITM) or you can create a combo trade where both legs would be ITM.

Let’s look at an example; we have a Gold binary with the underlying market currently trading at 1301.10.  You believe that the Gold market is going to remain stagnant to slightly drift higher for next 1 ½ hours before the expiration of the binary contract.  There are many strikes choices listed on Nadex to choose from but we are focusing on the 1300.0 and 1303.0 strike which will have a better return compared to if we chose strikes with a wider width. Using this strategy, the wider strike width actually increases the probability of a favorable outcome at expiration but it also increases the initial cost thus reducing ROI when compared to a narrower range.

We are buying the binary with the lower strike and selling the binary with the higher strike and anticipating the underlying market to remain within this range.

Combo Trade for Selling Volatility

Buy 1 - Gold (Jun) > 1300.0 at 75

Initial cost: $75/ contract

If the underlying finishes above the 1300.0 strike then the net profit would be $25/ contract

Sell 1 - Gold (Jun) > 1303.0 at 26.5

Initial cost: $73.50/ contract (100 – 26.5 trade price)

If the underlying finishes at or below the 1303.0 strike then the net profit would be $26.50/ contract

Combined cost = $75 + $73.50 = $148.50

Expiration Scenarios:

Gold Expires above 1303.0

Gold (Jun) > 1300.0 is worth $100/ contract

Gold (Jun) > 1303.0 is worth $0/ contract

Net loss at expiration <$48.50>

Gold Expires below 1300.0

Gold (Jun) > 1300.0 is worth $0/ contract

Gold (Jun) > 1303.0 is worth $100/ contract

Net loss at expiration <$48.50>

Gold Expires between 1300.0 - 1303.0

Gold (Jun) > 1300.0 is worth $100/ contract

Gold (Jun) > 1303.0 is worth $100/ contract

Net profit at expiration $51.50

*examples above are not inclusive of exchange fees

Potentially if the market remains flat and finishes within the two strikes you will receive a double payout but one binary leg will always finish in the money at expiration. The idea is your binary is already in the money so you want the binary to expire as quickly as possible; actually with binaries time decay works in your favor for ITM options.

Buying Volatility

If you believe the underlying market will be volatile and are perhaps cautious from trading due to the anticipated perceived risk then using binaries can be a useful tool to capitalize on your insight. The binary strikes that you would consider are OTM binaries which mean your initial cost is a much smaller portion of the maximum $100 expiration payout. (You are entering a trade at a disadvantage reflecting a lower entry cost)

Using this strategy, you can either buy or sell the binary strike outright (directional trade) which is out of the money (OTM) or you can create a combo trade where both legs would be OTM.

Let’s look at an example where we have the USD/JPY binary with the underlying market currently trading at 102.24 that expires in 8 1/2 hours. The dollar/yen market has been in a narrow trading range for quite some time and from our technical analysis, we are anticipating a big move in the dollar/yen.  In fact you believe a large move is imminent but can’t put your finger on it directionally.

A strategy you can use to capitalize on this market scenario is buying high binary strikes and selling the low strikes of the binaries.  You are taking positions with cheap entry costs but benefit if the anticipated underlying market move comes with a larger percent payout.

Again there are many strike choices listed on Nadex to choose from but we are focusing on the 102.60 and 102.00 strikes which are laid out below.

Combo Trade for Buying Volatility

Buy 1 – USD/JPY > 102.60 at 7.50

Initial cost: $7.50/ contract

If the underlying finishes above the 102.60 strike then the net profit would be $92.50/ contract

Sell 1 - USD/JPY > 102.00 at 83.50

Initial cost: $16.50/ contract (100 – 83.50 trade price)

If the underlying finishes at or below the 102.00 strike then the net profit would be $83.50/ contract

Combined cost = $7.50 + $16.50 = $24.00

Expiration Scenarios:

USD/JPY Expires above 102.60

USD/JPY > 102.60 is worth $100/ contract

USD/JPY > 102.00 is worth $0/ contract

Net profit at expiration $76.00

USD/JPY Expires below 102.00

USD/JPY > 102.60 is worth $0/ contract

USD/JPY > 102.00 is worth $100/ contract

Net profit at expiration $76.00

USD/JPY Expires between 102.00 - 102.60

USD/JPY > 102.60 is worth $0/ contract

USD/JPY > 102.00 is worth $0/ contract

Net loss at expiration <$24.00>

Futures, options and swaps trading involves risk and may not be appropriate for all investors.

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