Time for Volatility to Decrease?

Time for Volatility to Decrease?

Futures markets have traded at a higher level of volatility since the Brexit vote in Great Britain last Thursday; and as a result, option premiums tend to rise, giving more value to contracts that are further out-of-the-money. Today we will look at an example of how to potentially profit from a market when volatility is beginning to slow down.

Time for Volatility to Decrease
Time for Volatility to Decrease Getty Images

This example is given for illustrative purposes only and is not meant to be a trading recommendation. We will use a binary options strategy based on the S&P 500 E-mini futures, which is currently trading at 2042.25.  The example will be composed of two option legs.  When combined, these options give the trader a greater reward-to-risk than when either option is traded singly. Each of these options has a $100 base value per contract; and the options in this example will be based on the weekly settlement at 4:15 EST Friday.

The first leg of this trade example will be to sell the weekly 2060.50 option at the bid price of $23.25 per contract. This means that the potential reward on a weekly settle below the 2060.50 strike price is Time for Volatility to Decrease?limited to this selling amount, while the risk would be the difference between that $23.25 and the $100 value, or $76.75. Alone, this option would yield 33% return on risk if successful.

The second leg will be to buy the weekly 2024.50 option at the offer of $73.75. When buying the option, the risk is limited to the purchase amount, while the potential reward would be the difference between the amount paid and the $100 value ($100 – $73.75), which in this case would amount to a profit of Time for Volatility to Decrease?$26.25 per contract. As a stand-alone, this trade yields better than 3:1 return on risk.

When combining these two options in one trade, one of these options is guaranteed to expire profitably.  This reduces  the overall risk.  The combined risk is determined by subtracting the profit from one option from the total risk of the other ($76.75 – $26.25, or $73.75 – $23.25), or a total risk of $50.50 per contract.

In order to reach maximum profit, the trader needs the underlying instrument to close the week between the strikes of 2024.50 and 2060.50.  The maximum reward would be the profit from both options or ($23.25 + $26.25), or a combined profit of $49.50. So essentially, traders have the opportunity to earn nearly a 100% return-on-risk from a trade that allows a 36-point range of movement of the underlying prior to the close.

One additional thing to note regarding this type of trade is that if the S&P 500 futures starting trending, one of these options would likely lose money, but the other will likely gain in value; therefore, a trader may be able to exit this trade before expiration without taking on the maximum risk.

Note: Exchange fees not included in calculations.

The information contained above may have been prepared by independent third parties contracted by Nadex. In addition to the disclaimer below, the material on this page is for informational and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Please note, exchange fees may not be included in all examples provided. View the current Nadex fee schedule. Nadex accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representations or warranties are given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk and any trading decisions that you make are solely your responsibility. Trading on Nadex involves financial risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results. Nadex contracts are based on underlying asset classes including forex, stock index futures, commodity futures, cryptocurrencies, and economic events.

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