Binary Options Strategies
Binary options are a particular type of option where the payoff has one of two outcomes; you’re either right or you’re wrong at expiration. If the statement is true it settles at 100 and if not, it settles at 0. The profit or loss on the trade is calculated as the difference between the settlement price (0 or 100), your opening price and the direction you took. The most you can lose is the money you spent to initiate the binary option trade. When placing a binary option trade, you will always know your maximum possible risk and potential reward in advance.
Example: If you buy the binary at 38, your initial cost is 38. Net reward at expiration is 62, which is a 163% return. The seller of the binary at 38, has an initial cost of 62. Net reward at expiration would be 38, which is a 61% return. This is very unique trade because upfront you know exactly what the risk is and what the net payout/return is going to be at expiration. There is no in-between or variable at expiration.
When trading on Nadex, the binary bid-offer quotes are providing a trader the probability or likelihood for an outcome to occur. The true probability would actually be the midpoint of the bid-ask spread quote. The buyer’s probability would be midpoint and the seller’s probability would be 100-midpoint.
Using the example above, the 38 binary trade price represents a 38% probability for a favorable outcome to the buyer, a 62% probability for the seller. Similar to traditional options, time and the volatility are all factored into the binary pricing.
Binary Option Basics
Volatility - When volatility increases, the binary price will have a tendency to gravitate toward 50, the midpoint of the 100 point range, the market’s view is undecided of outcome. When volatility decreases, the binary price will gravitate toward the wings, either toward 0 or 100, where the market’s view of the outcome is perceived more predictable.
Intrinsic Value - Intrinsic value is considered the difference between the underlying prices relative to the strike price. How far over the strike, under the strike or at the strike is the underlying market.
Time - Nadex binary options have short-term hourly, daily and weekly expirations keeping the time premium, cost premium and cost relatively cheap. With traditional options, time premium is a decaying asset, with binaries time actually works in the favor for In-the-money (ITM) binaries. (The underlying market is trading higher than the strike or contract)
Binary Option Strategies
Directional Trading for Volatility - Let’s keep it simple. If you expect volatility to increase or are looking for a big move in the underlying market then you could use out-of-the-money (OTM) binaries (The underlying market is trading lower than the strike or contract). Dependent of your market bias, you’re looking for the underlying market to trade to or through the strike price level.
A strategy you might implement would be buying or selling binary options at a low entry cost relative to a higher net payout, similar to OTM puts or calls. You have a lower entry cost, a lower probability of success but a much higher percent return on the trade. Ready to trade volatility?
Directional Trading Strategies for Low Volatility or Flat Markets - If you are expecting volatility to decrease or the underlying market to be stagnant then you might be looking for ITM or ATM (In the Money or At the money) binaries.
One strategy could be buying or selling directional binaries at a higher initial cost relative to a lower net payout, similar to ATM or ITM puts or calls. Your initial entry cost increases which may lead to a higher probability of success. In turn, you may be receiving a lower percent return on the trade.
If you buy or sell directional ATM binaries, you will need the underlying market to move in your favor relative to the strike which provides a higher risk/reward ratio in comparison to the ITM binaries. With the ITM binaries, think of it as insurance that the underlying will finish favorably to your binary strike. This results in a higher initial cost because the market is already in your favor, thus lowering your risk reward ratio in comparison. Ready to trade volatile and flat markets?
Long Volatility Spread Strategies using Binary Options - By combining long volatility binary strategies, a trader has greater flexibility with market direction. By Buying OTM binary (high strike) and Selling ITM binary (low strike), a trader can capitalize on explosive moves of the underlying in either direction. Since all trades on Nadex are fully collateralized, the sell leg of the spread is a debit and therefore increases the total initial cost resulting in a higher breakeven.
At expiration only one leg of this spread strategy can be in the money but of course there is the possibility that both legs expire worthless. With that said, ideally you want the market to have a big move in either direction to cover the total initial cost and then some. The strategy is to lock in the profit on the one profitable leg and then have a free option hoping for a market reversal.
*Note: With the Long Volatility spread strategy, the closer the strike width (buying the high strike and selling the low strike) the greater the cost – the probability is higher for a successful trade. The wider the strike width (buying the high strike and selling the low strike) the lower the cost – the probability is lower for a successful trade. Ready to trade spreads?
Short Volatility Spread Strategies using Binary Options - When combining short volatility binary strategies, a trader has greater flexibility to capitalize on the market direction. Buying ITM binary (low strike) and Selling OTM binary (high strike), a trader can capitalize on flat grinding underlying markets.
Since all trades on Nadex are fully collateralized, the sell leg of the spread is a debit and therefore increases the total initial cost.
With this strategy, both legs of the spread can finish in the money or worse case only one leg in the money at expiration. Ideally you want the underlying market to be flat and finish between the 2 strike price levels. This strategy does require a much higher initial cost with higher probability, but risks more capital up front.
*Note: With the Short Volatility spread strategy, the closer the strike width (selling the high strike and buying the low strike) the cost is less and the probability is lower for a successful trade. It is harder to predict that the underlying market will finish in a tighter range. The wider the strike width (selling the high strike and buying the low strike) the cost increases and the probability is higher for a successful trade. It is easier to predict that the underlying market will finish in a wider range.
The Bottom Line
Ready to start trading binary options on some of the most heavily traded forex, stock indices and commodities markets with low collateral and completely limited risk?
You can create a Nadex account for free in five minutes and start trading binary options or open a demo account, with $25,000 in practice funds, to test drive the Nadex trading experience.