Currently, it’s Friday around 7:00 a.m. EST, and the S&P 500 is trading at 2411.50. Yesterday, the index reached a new all-time high, closing above 2400.00 for the first time in history. However, with the GDP release scheduled for today, and knowing that Fridays can tend to be slower, one potential market view could be to look for the market to close lower by end of day today.
Binary options offer creative trading opportunities as long as you have a market view. Using the idea above as an example of a trading viewpoint, we will look at a 1×2 strategy, looking for the index to settle below yesterday’s high by the end of day today. Please keep in mind that this is an example, not a recommendation of a market view or strategy. Binary options can be traded in many creative ways; this is just one of them.
In this 1×2 trade, looking for the market to close lower, you would short one 2400.00 strike and two 2424.00 strikes.
To trade binary options, you need a price target, and you would decide whether you believe price would close above or below that strike at a certain time. Various expirations and strikes are available, so you would locate the ones that fit your need on a binary options table such as the one below.
Currently, the 2400.00 binary strike that expires at the 4:15 p.m. EST close can be sold for $90.50. To short this strike would mean that you believe the market will close lower by end of day today than it did yesterday. These option contracts have a settlement value of $100 each. The seller of this option can earn the $90.50 selling price on a settlement below 2400.00 while risking the difference between the potential profit and the $100 contract value, which amounts to $9.50.
If you wanted to sell this option, and had a bearish view, you could offset the risk with the second leg of the trade – selling two of a higher option strike. In this case, you could select the 2424.00 option and offset the $9.50 risk of the 2400.00 option above by selling two of the 2424.00 strikes for $6.00 apiece, totaling $12.00.
This $12.00 profit would cover the cost of the $9.50 on the short 2400.00 option, but then there would be additional risk on the two 2424.00 short options, which would total $188.00, or the $94.00 risk on each option multiplied by two. The dollar amount of risk is much higher, but the strike is also high enough above current price that the probability of success that the market will close below this strike is perceived as high.
The combined risk with the short 2400.00 and the two 2424.00 options would be $197.50 ($9.50 + $188) to potentially earn $102.50 ($90.50 + $12.00). The $197.50 risk in this example would only be realized on a daily settlement above 2424.00, while the potential maximum profit is reached on a settlement below 2400.00.
Selling the two higher strikes helps offset a potential loss from the lower strikes if the market closed in between the strikes – below 2424 but above 2400 – because the $12.00 profit from the 2424.00 would offset the $9.50 loss from the 2400.00 ($12.00 – $9.50),s which still amounts to $2.50 in profit even if the lower strike loses.
This 1×2 trade examples shows that while protecting yourself from potential loss, you have the potential to earn the higher amount of $102.50, which would be over a 50% reward on on the $197.50 risk.
The flexibility of these options provides you with many ways that you can create your own spreads that will potentially offset risk or give your trades another angle. The possibilities are nearly endless.
For example, if you have a different view of this market, you could trade the same strikes from a bullish viewpoint. When buying a binary option you want price to settle above the strike while risking the purchase amount, with the potential reward being the difference between the purchase amount and the $100 settlement value. The 2400.00 strike could be purchased for $94.25, risking the purchase price to earn $5.75 on a settlement above 2400; or a trader could even decide to buy the 2424 strike for $7.25, risking that to potentially earn $92.75.
Of course, with all the other option strikes available on the table, as well as strikes with other expiration timeframes and on other instruments, your choices are not limited to strikes that are far from current price; there are many ways for you to consider how binaries can enhance your market view.
Note: Exchange fees not included in calculations.