Creative Binary Choices with the VWAP

Creative Binary Choices with the VWAP

The Volume Weighted Average Price indicator, or VWAP, is a type of moving average that considers volume when determining its average. The popularity of these indicators has grown to the point where many automated trading programs include the VWAP in their algorithms.

Creative Binary Choices with the VWAP
Creative Binary Choices with the VWAP Getty Images

In previous articles we have looked at the Volume Weighted Average Price indicator or VWAP, which is a type of moving average that considers volume when determining its average.

The popularity of these indicators has grown as traders both in the retail world as well as in institutional trading have discovered the usefulness of these levels, to the point where many algorithms that conduct automated trading also include the  VWAP in their programs.

In prior articles, we looked primarily at the daily VWAP, but today we will consider VWAPs on a weekly and monthly basis.  The chart of the S&P 500 futures show the weekly VWAP in green and the monthly in red. Note that price is trading around 2343.50; this means that it is close to halfway between the two VWAPs, which are located around 2338 on the weekly and 2348 on the monthly.

Creative Binary Choices with the VWAP

With these two levels just 10 points or handles apart, the theoretical likelihood exists that at least one of these levels will be tested today.

For traders who like to use price levels, binary options are an excellent complement to the VWAP indicator because of the yes / no proposition they offer, based on a specific time and price at expiration.

The VWAP can be traded in many ways, and there are several ways to implement binary options into these strategies. Today we will look at just one way binary options can be traded with the weekly and monthly VWAP; but please note that if your market view differs from the theoretical view used for this illustration, there are many alternative ways to trade that enable you to craft a trade the suits your own unique view.  The illustration used is not a recommendation of any trade or strategy, but is used as an example of how binary options may be traded.

The daily binary options below table provides us an indication of which options coincide with the VWAP levels on the chart above.

Creative Binary Choices with the VWAP

To use this strategy, traders would look for binary option strikes close to their desired price targets on a binary options table.  The table above shows daily binary strikes available which expire at today’s 4:15 p.m. EST close.  The strikes on the table provide an indication of which options coincide with the VWAP levels on the chart above (2338 and 2348), and it appears that the 2347.00 and 2338.00 options align most closely with the VWAP levels.

When buying a binary option, you would want the underlying market price to be trading above the strike at expiration while risking the binary purchase price amount to earn the difference between the risk and the $100 settlement base value of the option. When selling an option, you want the underlying market price to settle below the strike, with the potential reward being the binary sale price and the risk being the difference between that sale price and the $100 settlement base value.

For this example, let’s say you want to set up a strategy that would profit on a move and possible settlement either above the monthly VWAP or below the weekly VWAP.  In that case, you could either buy the 2347.00 strike for $36.75, risking that amount to potentially make $63.25 on a settlement above the strike; or, if you believe that the weekly VWAP will be tested, you could sell the 2338.00 option for $70.75 with the potential to earn that amount while risking $29.25.

Now if your model suggests that one of these levels will be tested but you have no indication on which side it will occur, then you could combine the purchase of the 2347.00 strike with the short 2338.00 strike.

In this combined trade, the risk from both sides of the trade is added, which combines to $66.00 and would be realized on a settle in between the strikes. However, this trade would result in a $34.00 profit on a settlement outside of either strike, no matter which direction.

Of course, traders with the opposite view on the direction this market will take could sell the 2347.00 strike if they believed price would settle below the strike, or buy the 2338.00 option if they believed price would settle above that level.  As long as a trader has a price target in mind, binary options are a very useful trading method due to their predefined risk and flexibility.

Note: Exchange fees not included in calculations.

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