Stock indices with binary options

June 15, 2015 12:06 PM

Even though the S&P 500 held support again on Friday, May 29, falling from its previous up breakout last week, it still feels vulnerable. Whether it stalls or makes a move this week, there’s a way for traders to take advantage of their view on exactly where this market is headed—and they can do so with limited risk using binary options.

On the North American Derivatives Exchange (Nadex) you can take a view on a range of global stock indices using binary options and spreads, with low collateral requirements and defined, limited risk.

There are several benefits of using stock index binary options: You can trade binary options whose values are calculated with reference to key underlying stock index futures; short-term expirations offered range from 20 minutes to one-week for U.S. and International stock indices; and you can find low collateral with capped risk while the maximum profit/loss is always known.

On Nadex you can trade binary option and spread contracts based on the underlying futures prices of several stock indices from the United States and the rest of the world.

Nadex is a Chicago-based exchange that allows traders to trade currencies, commodities, indices and even news events at a quick pace. These derivatives can be traded on a 2-hour, daily and weekly basis. The most intriguing part of Nadex may be the risk to reward ratios available with fees as low as $0.90 per contract, all while knowing your maximum profit and loss for every trade you make. Nadex binary options give you the ability to spot market trends and limit trade risk, as well as the ability to trade out of contracts before expiration.

Another popular way to trade on Nadex is through their spreads. Nadex spreads are derivatives with built-in ceiling and floor levels, which show the highest and lowest points the contract can settle. Their ranges vary depending on the underlying market (indices, commodities and currencies) along with how much time there is until expiration. 

For example, since the Dow Jones Industrial Average Index is much larger than the S&P 500 index, the Wall Street 30’s spread range will be larger than the US 500’s.  Similarly, a contract that expires at the end of the day’s spread range will be wider than those that expire intraday or every 2 hours. The range values are related to a function of time. The longer the duration the wider the spread or the greater the dollar value. The shorter the duration the narrower the spread or the less the dollar value.

The range of the spread represents the maximum profit and loss (the ceiling and floor). When buying a spread, every dollar above your purchase price up to the spread’s ceiling is your potential profit and every dollar below your purchase price down to the spread’s floor is your potential loss. When selling a spread, every dollar below your selling price down to the spread’s floor is your potential profit, while every dollar above your selling price up to the spread’s ceiling is your potential loss.

Suppose the S&P 500 is trading at 1307 at noon and you believe that is as low as it’s going to go for the next hour.  You could buy the “US 500 1305.0-1315.0” spread that expires at 1 p.m. for about $20 (the closer to expiration the lower the premium). 

There are two prices to be familiar with: The underlying and the Nadex US 500, which is based on the CME E-mini S&P 500 Index Futures. The 1307.0 price subtracted from the floor of 1305.0 equals a $20 cost. All spreads have a minimum tick equal to $1. For the US 500 the minimum tick is .1 = $1

In this scenario, your maximum gain would be $80 if the CME E-mini S&P 500 Index Futures close at or above 1315 at 1 p.m. and your maximum loss would be that $20 initial purchase if the Futures contract closes at or below 1305 at 1 p.m. The Nadex price would be 1307.0 (1305.0 floor +20)). If the Nadex expiration value for the US 500 is at 1313 at 1 p.m., then your profit would be $60, but if the S&P 500 closed at 1306 at 1 p.m., then your loss would only be $10.  Any price in between, you are getting funds back—but the question is it a profit or loss?

On the other hand, if you thought the S&P 500 was at its high for the next hour, you might sell the “S&P 500 1300.0-1310.0” spread that would also expire at 1 p.m. for about $30. Your maximum gain would be $70 if the S&P 500 closes at or below 1300 at 1 p.m., while the maximum loss would be $30 if the S&P 500 closes at or above 1310 at 1 p.m.  All examples above not inclusive of exchange fees.

One issue is that the Nadex pricing is different for each spread due to the relationship of the spread in-the-money, at-the-money or out-the-money. You can’t assume the Nadex price is the same: The underlying futures is constant but the Nadex price differential is either an edge that you receive or give to the trade advantage.

However, what’s unique about Nadex is the ability to always know your maximum potential gains and losses, which provides better risk management for any trader, whether you prefer to risk $10 to potentially make $90 or would rather risk $80 to potentially make $20.

Binary options make it possible to find trading opportunities even when the underlying stock index is quiet, and Nadex is one way you can make those plays.

Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.
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