The Risk and Reward Trade Off in Binary Options

The Risk and Reward Trade Off in Binary Options

It’s important for binary options traders to understand their exposure and how different types of options are going to respond to moves in the underlying market. Binary options are short dated derivatives and in general traders are able to set up positions that can see a large change in value on only a small move in the underlying market.

The Risk and Reward Trade Off in Binary Options
The Risk and Reward Trade Off in Binary Options Getty Images

For a trader that understands this it is a huge benefit. When markets are trading in tight intraday ranges they are able to set up trades using binary options that can still give them a good reward to risk ratio in that tight range. To take full advantage of this dynamic a trader has to understand the different approaches they can take to a trade signal using binary options. Here we will break down the main differences between in the money, at the money and out of the money binary options and why a trader may choose one over the other in a trade setup.

First a trader has to have an opinion on the market. The CME E-Mini S&P 500 Futures are currently trading around 2267.75 and a trader thinks the market is going higher. We will examine the risk and reward tradeoffs in three different trade setups.

A trader buys the US 500 > 2270 Daily Binary Options for $35
Risk: $35 per 1 lot
Reward: $65 per 1 lot

This trade gives a trader a large reward to risk ratio. The trader is getting nearly 2-1 on their money and they only need the market to rally 2.50 points by the end of the day for this option to go to full value. It would be very difficult for a trader to replicate this risk to reward setup in the futures unless they wanted to use a very tight stop. If a trader didn’t expect the market to move much higher from its current levels they could use a trade setup like the one below.

A trader buys the US 500 > 2267 Daily Binary Options for $52
Risk: $52 per 1 lot
Reward: $48 per 1 lot

This trade does not offer as strong of a reward to risk setup but these options are in the money and the market does not need to move any higher for this trade to settle at maximum value. The trader would put this trade on if the expected the market to trade flat to slightly higher through the end of the session. The trader is still able to give themselves the potential for a 92% return on risk. It would be impossible for a trader to replicate this dynamic in the futures. One even more conservative approach is shown below.

A trader buys the US 500 > 2264 Daily Binary Options for $70
Risk: $70 per 1 lot
Reward: $30 per 1 lot

This trade has the worst reward to risk setup of the three examples but it also gives the trader the biggest downside cushion. As long as the market is above 2064 at the close this trade will settle at full value and the trader will profit 43% on their risk. This means that the market can rally, trade flat, or sell off some and this trade could make money. Again this would be impossible to replicate in the futures market and the increased scenarios of profitability lead to a lower potential ROI.

As you can see binary options provide a trader with an array of choices. They are able to set up risk and reward profiles that they are comfortable with and positions that fit in best with their expectations. If you are looking for a way to trade small ranges and are interested in the flexibility detailed above you really need to look into binary options.

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