When you trade Out-Of-The-Money (OTM) binary options, you are placing a lower risk premium for a potentially higher reward, per contract traded. Since binary options are bundled in $100 contracts, OTM trades could risk $10 to make $90, $20 to make $80, or $30 to make $70, for example. At the time you place an OTM trade, the market is not in your favor, and the probability of a successful trade is also lower. The lower your probability of success, the less risk premium is assessed.
Sometimes traders ask “Why would I want to risk $20 to make $80 if the odds are stacked against me? Isn’t that just throwing money away?” While that reaction is natural, you are also placing a trade where you are expecting a price move, such as a breakout to move in your favor. When you trade OTM binaries, it’s important to have a breakout or reversal strategy that you have tested successfully in the past.
Here are some tips for trading OTM binary options:
- Your trading strategy needs to have a decent chance of success . If you are going to risk $30 to make $70, then you should be trading a strategy that has a demonstrated historical success rate of 40% or better. If the odds of success are greater than the amount risked, then you are trading with the odds and history on your side.
- The more time left in the trade until expiration, the better. If you are placing an OTM trade expecting a 6 point move in the E-mini S&P Futures market, you need to give the trade enough time for the market to reach your target. Your probability of success is greater if you have 2 hours to reach that target, compared to, let’s say, 20 minutes.
- OTM trades can be good trades before major economic news reports. If Crude Oil jumps on the weekly inventory report, then an OTM trade placed before the news release can help you capture the expected spike or drop in the price of Crude Oil after the news reports is released.
- Know how to manage your losses. When you trade OTM binaries, you have a reduced exposure to risk, but that risk can still sometimes be managed. If you are risking $30 to make $70 and the trade isn’t behaving the way you expected, you may be able to exit the trade and reduce your losses.
Here is an example using OTM Binary Options to hedge an expected breakout in the E-Mini S&P 500 Futures market on February 19, 2016.
The US 500 Index which is based on the CME E-mini S&P 500 futures had been on a sharp downtrend from 4:00 am EDT until the Opening Bell at 9:30 am on this Hourly Chart. Shortly after the Opening Bell, the market bottomed out at a major support level and traveled sideways for 20 minutes on the 5-minute and 1-minute charts.
The US 500 Index was in a congestion phase going into the 10:00 hour, trading around the 1902 price level. The market had just opened, and it looked like a breakout was imminent. But which way would the market break? Would it move upward and pare some of the losses from the morning downtrend, or would the downward slide continue?
The decision was made to hedge the expected breakout with two OTM binary options trades, using the 10am-12pm time frame:
- 10:02 am – BUY >1908.9 (12pm expiry) at $25. Maximum Risk, $25, Maximum Reward $75
- 10:02 am – SELL >1895.4 (12pm expiry) at $72.75. Maximum Risk: $27.25. Maximum Reward $72.75
With almost 2 full hours left in the trade, the market would need to move roughly 7 points in one direction or the other. The total exposure to risk was $52.25 for a maximum reward of $47.75. The worst case scenario would have been if the market continued to drift sideways for 2 hours from 10am – 12pm. If that had happened, then both trades would have been exited early to minimize losses.
Shortly after the trades were placed, the market broke out to the upside, blowing through the upper 1908.90 BUY strike price and settling in the money at 1911.25 at the 12pm expiry, resulting in a $47.75 maximum reward (exchange fees not included).
This strategy, also known as a “strangle” can be an effective way to trade OTM Binary Options. The two essential ingredients are that you need an expected sharp movement in the market, coupled with enough time to let the market get to your destination.