Playing the range with binaries

June 23, 2014 05:49 PM

The problem with trading in a low volatility environment is that those traders who write options have to get closer to the flame and can easily get burned.

Traders like to trade, but with premium values shrinking this type of strategy gets dangerous particularly for traders that like to constantly work a position. In order to get any decent premium you must write options closer to the money and closer to expiration.

An alternative in these low volatility periods is using binary options where your risk is limited.

Low volatility traders are struggling to find opportunity. There could be a big move at some point, but no one knows when, so traders still need to find a way to be protected. Options traders could write options to try to create opportunities, but as noted above, there is no decent premium to collect, and there is a whole lot of risk involved if the market quickly turns from low volatility to high.

With binary options you can create what essentially is a range bound, or slow moving market—a strategy that can be used in an intraday, a daily or a weekly basis.

For such a strategy, you would need two legs: buy an in-the-money binary trading somewhere around 70-80 and sell an out-the-money binary trading around 20-30.

During periods of low volatility, more traders are inclined to think that the option will end up in-the-money, and traders will be inclined to buy it. Since more traders are buying, the price will go higher. Therefore the price of an in-the-money option is higher during periods of low volatility.

Let’s take a look at an example. If the E-Mini S&P 500 is trading at 1960, there may be a daily binary strike of 1969 trading at say 25 and a daily binary strike of 1951 trading around 75. The best-case scenario would be for the market to stay between 1951 and 1969, in which case a trader would collect $25 per contract, or $50.00 for the whole position.

The worst case scenario is a close below 1951 or above 1969, which—if the trader held until expiration—would be a loss of $75 on one side and a gain of $25 on the other for a total loss of $50. Again, this is an absolute worst case no matter how far the market moves, unlike a short option position.

If a move does happen early enough, a trader may be able to close out with still some time value in the losing contract—say, for example, the E-Mini S&P 500 moves up 9 points early in the day and the in-the-money option bought at 25 is now trading around 50. The trader can close out early to limit those losses on that leg and hopefully create a wash with a $25 gain on the other leg.

Examples above not inclusive of exchange fees.

Stay tuned, as we will continue to bring you different scenarios each week of how to properly use binary options.







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