Buy the Stock Market (Really)
Stock index funds outperform stock pickers long-term. Use that index advantage in short-term trading with binaries.
Here’s a simple trading example that shows the power binary option trading offers to individual traders. It’s a power that used to be available only to a few, with millions in their accounts: stock index futures. Index futures let you trade the stock market as a whole.
When mutual or pension funds want to hedge against losses, they used the S&P 500 index futures. The margin requirements are in the tens of thousands and so is the risk. In the days of the active trading pits, traders could make a fortune before lunch and lose it again by the end of the day. Later, options and the electronic mini contract reduced the amount you needed to trade, but not necessarily the risk.
Mainstream investing seems less risky, but while individual stocks and managed funds can offer great returns for a few years, they rarely outperform the market. That led to rise of the index fund, based on the idea that individual investors could essentially buy the market as a whole. Index funds opened up new possibilities for long-term investors.
With binary options, short-term traders have a limited risk way to use the power of stock indexes. You can take short-term positions based on what you think markets in the US, Europe, or Asia are going to do in the next few hours or even minutes.
What’s more, binary options make it easy to short-sell. Most investors and even day traders are only comfortable with the long side, buying when they think the market will go up. But markets go up, down, and even sideways. Binary options offer profit opportunities in all three directions.
Every binary option trade has four basic steps:
- Choose a market to trade and the time frame you want to trade
- Choose a strike price you think the market will be above or below at expiration (or before)
- Buy or sell for an amount you are willing to risk
- Manage the trade until exit or expiration
1. Choose your market and expiration
In this simple example, you’re going to buy a US 500 binary option with the expectation that the stock market is going up in the next half hour. The market has been going down since the open, but now seems to have found support and started to bounce. At 12:30pm you decide to buy the US 500 two-hour binary, expiring at 2pm.
What if the price continues down? You can exit at any time, but since you have the built-in protection of knowing your maximum possible loss up front, you’re going to use that to your advantage. Your plan is to buy an option that is relatively inexpensive, so that you can profit even if the market doesn’t go up very far. You have a range of strike prices to choose from, some further out of the money, some close to the market’s current price.
2. Strike price: your line in the sand
You want this trade to be in the money as quickly as possible, so you make the straightforward choice of 2073.8, the strike price closest to the market. You can get it fairly cheap since the price has been dropping all morning. Most traders think the price will continue down, so the buy price is relatively low.
A great feature of Nadex ladder charts is that you can see the live chart along with the order ticket. You choose:
US 500 (Sept)>2073.8 (2PM)
3. Place your order
While the current offer price (the price you’d buy at) is around $40, you’d rather hold out for a price closer to $30. You type $32 into the price box. You know there’s a chance the market could take off and not give you that price, but you’re looking to buy low and sell high.
Almost immediately after your order is filled, you find yourself losing money! It turns out the offer price not only went down to 32.00, it went even further. So you start off in negative territory. However, you know what the maximum possible loss could be: $320.00 plus $9.00 in fees. For even more security, you can exit the trade with a smaller loss at any time.
In this case, you decide to hold on and give the market a chance to move up.
4. Manage your trade until exit or expiration
Knowing that your maximum risk is limited to an amount you decided on helps you focus on something other than that loss, which may or may not be temporary, but is definitely capped. In this example (at the time of writing), it turns out the trade did start to turn profitable after five minutes.
The value of the option continues to go up. At this point, you have the choice to do what traders call the “Steve Miller Band” move—take the money and run. You’d have made $75 in about 10 minutes, having risked a maximum $320.
But let’s see what happens if you hold onto the option a while longer. You still have 45 minutes to expiration and the trend seems to be up.
The underlying indicative index price pops up above the strike price. That increases the probability that it will be in the money at expiration. The market responds by increasing the volume and price at which the binary option is traded. The price quickly goes to $212.50.
From $212.50 it drops within a couple of minutes to $177.50. This is a fast market! And you may decide to just take profits now. A $159.50 profit (after the $18 fee) is great. Still, now it might seem kind of small compared to the $203.50 you had just minutes ago. And you recall that the maximum potential profit on this trade is $680.
In another minute or so, the binary option’s price has almost doubled to $327.50. Your maximum risk on this trade, the amount you paid to get in, was $320. Even with fees, you’re now up over 96%. Remember, this is just what the market happened to do at the time of this writing. It could just as easily have been less profitable or even unprofitable. Moreover, you had opportunities in the last half hour to get out with a small loss, a small profit, or a 50% profit. All of these would have been sensible decisions depending on your trading style and priorities.
Anyway, the market went even further and got close enough to the maximum possible profit of $680 that it made sense to just take profits rather than wait another 37 minutes. After all, the market went up a lot in about half an hour. It could just as easily go back down in the next half hour.
You exit by clicking on either the Sell button on the chart (at the same strike price) or on the name of the contract in your Open Positions list. An order ticket pops up already filled out with the same number of contracts and the price at that moment. You can take that price or set a different one. In this case, even though the Bid price was 83.00, we offered 84.75. (We weren’t being greedy; it was fluctuating between 83 and 86.) Because our offer was close to the live price, we got filled in seconds with a profit of $510. Subtract $9 in trading fees and another $9 in settlement fees for a profitable trade, and we have $492.
That’s a 154% return in less than an hour. Of course, not all trades go this well. And you might have taken profits $200 or $400 earlier or even gotten out with a loss in the first few minutes. But at no time would you have worried about how much you might lose, since you knew that number when you placed the trade.