We have featured many articles that deal with the creativity and flexibility that binary options offer traders. One of the most attractive strategies is to sell out-of-the-money options with a higher theoretic probability of success, but with a less favorable risk to reward. This strategy can be helpful, but it is important not to jump into trades that look like easy money without managing your risk.
For example, with the S&P 500 futures trading at 2413.50, the 2427.50 weekly strike that expires on Friday’s 4:15 p.m. EST close looks attractive.
The 2427.50 strike can be sold for $13.25 per contract. Since it is above where price is currently trading, selling this option may seem favorable, and perhaps a highly probable way of earning $13.25 per contract purchased. This option would profit as long as the close on Friday is below 2427.50, and would be entered by traders that are basically expecting sideways movement in the market by the end of the week.
However, when selling these types of options, eventually a position will go against you. When you sell an option, the risk is the difference between the sale price and the $100 settlement value, so that means the risk would be $86.75 in this case. While the $13.25 profit can look like easy money to traders, it’s when one loss such as this $86.75 amount is realized that the pain sets in. Even worse, if you have traded several of these contacts, thinking they could be easy money, that the trade becomes even more painful.
So what can you do to manage your risk? When trading with this kind of low return on risk, you have to be accurate about 80% of the time to come out even a little ahead, and a bad run of losing two out of three can really hurt.
Let’s look at some risk management concepts that could help you control risk and avoid a big loss. Please keep in mind that we are using this trade to illustrate risk management; the purpose of this article is not to give a recommendation of any market view or specific trade idea.
One way to manage risk is to use a tight manual stop loss. For example, if you sell the contract for $13.25, you could close the position once the bid price doubles, or becomes $26.50; and with its current $5.00 bid/ask spread, that would mean that you may reduce your risk to $18.25 to earn $13.25. This would likely lower your winning percentage but make it easier to sleep at night.
Another risk management technique is to wait until the option gets to the strike price and close this position when the mid price (between the bid x ask) is around $50.00, representing the market’s perception of now having a 50/50 chance of expiring in or out of the money. In this scenario, you may close this position around $52.50, hypothetically risking $39.25 to make $13.25, or a 3:1 risk versus reward. Both of these methods involve reducing the dollar amount of risk on the losing trades so that it takes fewer winning trades to offset them.
Lastly, you could hedge your position by using any of the other options available; but caution is key – sometimes hedges, unless done with much thought, can increase your risk exposure, and they may not be implemented carefully during the emotion of a losing trade.
Finally, one thing you should NOT do is rely on hope and prayer. There is nothing worse in trading than the out-of-control feeling of watching a trade go against you when you are risking a lot to make little. In many cases, enough time is available for you to make adjustments to your trades before feeling the full impact. Remember, you cannot control the market, but you can govern your position accordingly; and when a trade is going against you, sometimes the worst thing that you can do is nothing.
Please be mindful of this when trading out-of-the-money options – it is important to have a plan before you enter the trade, and not to trade on emotion.
Keep in mind again that the example above of selling this strike is just one possibility of how to trade binaries. Options can be traded in other directions; for example, if you believed this market was going higher, then you could buy this same 2427.50 weekly option strike for $18.25, risking amount that to potentially earn $81.75 on a settlement above the strike; or you could use any of the several option strikes available, either individually or in combination, to implement your own market view.
Note: Exchange fees not included in calculations.