Trading with boundary binary options

July 1, 2014 08:00 AM

When you trade call and put options, you are predicting where the underlying asset’s price will be at a certain time and date. When it comes to binary options, a variation of option contracts, you predict whether the underlying asset’s price will reach certain price levels, or not. Using binary options to trade the anticipated range of the market is a little different. Using binaries, the trader has the opportunity to speculate if an asset’s price will stay within a confined price range for a certain period of time. 

The binary option has an all-or-nothing expiration value, meaning that they will either expire in the money or out of the money; there is no in-between. As a result, using binaries can be a particularly useful method to trade when the markets are trading sideways.

Range trading offers flexibility for binary options traders and is an excellent way to enhance profits in most market conditions. Traders have the option to either agree or disagree with price remaining within the predetermined range and therefore this can potentially favor both trending and range-bound markets. The general rule for range trading is the tighter the predetermined range, the more profitable a close in-the-money will be.

Binary options in range-bound markets can be easy to use. A trader chooses an asset, the expiration time, and two strike levels: the first strike level is lower than the current underlying value and the second strike level is higher than the current underlying value. If the asset’s settlement value is between these two strike levels at the expiration time, then the trade will close in-the-money on both binary positions. But if the settlement value is below the lower strike or above the higher strike at expiration, then only one of the binary legs finishes in-the-money and the other leg is worthless, finishing out-of-the-money.

A simple way to describe range trading is identifying a higher and lower strike level within which the underlying value will remain between for the lifetime of the strikes that you select. 

Last week provided an example that could carry on into this week in the E-mini S&P. After closing the previous week at an all-time high, the E-mini probed higher and settled below that high on Monday. On Tuesday it failed at the high again before reversing lower. On Wednesday the sell-off failed to carry through, despite an extremely bearish GDP number, setting up a solid range of 1960 on the top and 1936 on the bottom. At this point a clear range was in play that could be exploited. Thursday confirmed this with a doji pattern. If you thought that price would remain within that range for, say, the next day, then as long as the E-mini S&P future finishes within the upper or lower boundary, your binary option would expire in-the money on both legs.  Remember this is not a one touch so it’s all about what happens at expiration. With this type of binary strategy, the initial cost is generally higher due to both binary positions being in-the-money at the time of purchase, however, upon expiration there is always at least one leg finishing in-the-money, and receiving the $100/contract expiration value.

The best way to detect a range-bound market is to use an indicator that shows you exactly which direction the market is trading, such as Bollinger bands or the Moving Average Convergence Divergence.

With last week’s near double doji close another strategy may emerge. Often dojies indicate a trend reversal or increase in volatility. A trader who believes this is immanent could reverse that strategy and make a bet the market will breakout of its specific range.

In the coming weeks we will cover other ways to use binary options.


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