When trading binary options, you probably know there are in the money, at the money and out of the money contracts available. All have their place in trading. All have their inherent risks and rewards. If you are new to trading binary options, or have traded binary options with another company besides Nadex, you may not realize the benefits of trading out of the money binary options. This article will focus only on out of the money contracts.
The definition listed at Nadex for out of the money (OTM) binary options from the buy side indicates, “when the underlying (indicative) market price is less than a binary option’s strike price, the binary option is ‘out of the money.’ At the expiration settlement, only binaries that finish in-the-money will receive the $100 payout, so an ‘out of the money’ will expire at zero. Prior to expiration, the binary option will have a variable value based on how close it is to the strike price and time remaining.”
To simplify, think binaries priced below $50 for a binary buyer and above $50 for a binary seller are OTM. The binary price has to move in your favor for the contract to be profitable at settlement. If you are buying, the binary price has to move up toward the 100 cap and if you selling, the price must go down toward the 0 floor. Remember with an OTM contract, the binary price just has to move farther up or down in your direction to be profitable, you don’t have to wait until expiration.
How can this play to your advantage?
All OTM contracts will have a lower initial cost/ risk because it has a lower probability of finishing in the money compared to the other binary strikes. However if the binary does finish in the money, the return on the trade is much higher. Having a profit target of say $20 for an OTM binary trade can have a nice ROI . Assume you initiate a buy for a binary at the price of 15 and close out the position at 35 ($20 profit) which is a 133% return where the underlying is still below the strike.
Risk vs Reward on Binaries: Long position
If you buy one Nadex binary at $25, your maximum risk is $25. When buying or going long, your risk is what you paid to get in the trade. The idea is to go in a buy low and sell to get out when the market hits your strike price. The image below illustrates how time can also affect the price at which you may buy your contract. You may buy at 38 and get out at around 50 when the market hits your strike. On the other hand, you may have bought at 26 and get out at around 50 when the market hits your strike. You may have possibly been able to do both. The idea is not to buy and hold the contract until expiration, but to buy it and make a quick profit.
Risk vs Reward on Binaries: Short Position
If you sell one Nadex binary at $72, your maximum risk is $28 per binary. Again, the idea is to go in and sell out of the money at about $75. When the market gets close to the strike, then you buy it back for around $50 and you get out. Maybe it would have gone further down and you could have made more, but maybe not. You just want to make about $25 quickly.
Cheap, Close, OTM
Keep in mind that you want a cheap close OTM contract, not one that the market will have to move eight or nine ticks in the next couple of minutes in order to be profitable. Remember, the market must move in your direction far enough and fast enough to overcome the bid/ask spread before the contract expires. (Bid/ask spread is the difference in those two prices when entering a trade. You are automatically losing a small amount until that difference is overcome.)
Trade OTM binary options on market breakouts and directionally. They offer low risk and higher reward, as long as the market moves far enough, fast enough. Being OTM, they have a lower probability of that happening. However, this is another optional strategy to experiment with in your Nadex demo account before trying it live.