Use Binary Options to Trade Volatility

Use Binary Options to Trade Volatility

 

There are two types of volatility, historical and implied. Historical is simply the changes of the underlying asset’s price previously during a certain period. Implied volatility, then, is the market’s collective expectations about the performance of the asset in the future. A prudent trader is always aware of what the historical volatility has been and what the implied volatility is predicting the moves will be, as both of these factors are key to making the right decision on a binary options contract.

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The components used for an option’s pricing are the same in Binary options and classic options: market conditions of the underlying asset, the strike price of the option, volatility and time to expiry. Determining the price of a binary option is indeed the consensus of the market that there will be a certain outcome at a specific time. Pricing is highly affected by these important components, but let’s discuss the short-term opportunities that come with using binary options for trading volatility.

Using a flat market to your advantage with binary options

If you think that the underlying market will be still and/or will remain within a certain range, you can use binary options effectively to capitalize on your insight. The ITM (“In the Money”) binaries are the binary strikes to be considered, which means your initial cost is a larger portion of the maximum $100 expiration payout. Here, you are paying for the immediate advantage; higher probability of success = higher initial cost. This strategy allows you to buy or sell the binary option contract immediately which is in the money, or to create a combo trade where both legs would be ITM. In the latter case, if the market remains flat and finishes within the two strikes you will receive a double payout, but one binary leg will always finish in the money at expiration. As your binary is already in the money, you want the option to expire as quickly as possible; actually with binaries time decay works in your favor for ITM options.

How to trade binary options in a volatile market

If you believe that the underlying market will be volatile, and are prudent when it comes to trading in regards to the expected risk, then using binary options can be a useful tool to capitalize on your perspective. You would consider the OTM (“Out of the Money”) contracts, meaning that your initial cost is a much smaller portion of the maximum $100 expiration payout. As with the ITM binaries, the initial cost is related to the probability of success. This strategy allows you to either buy or sell the option immediately (directional trade) which is out of the money (OTM), or you can create a combo trade where both legs would be OTM.

There is a strategy that can be used to capitalize on this market scenario, which is buying high binary strikes and selling low strikes. Taking positions with cheap entry costs and making profits if the anticipated underlying market move is correct will come with a bigger percent payout.

 

 

 

Benefits of Exchange Traded Binary Options

Benefits of Exchange Traded Binary Options

 

There is a lot of confusion about binary options, but the simple truth is that they can be a great trading instrument as long as they are structured properly and traded on a regulated exchange. Generally, all binary option contracts share the same name, but there are many different types of them. Basically, all binary options share one characteristic: that is, there are only two potential outcomes, “all or nothing”. For many of the financial instruments sharing this name, however, that is where the similarities start and end.

 

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Legitimate binary options trading

If you have ever had a negative feeling upon hearing the term “binary option”, maybe it is because you have heard of, or even participated in trading binary options at off-shore firms. The number of firms like this has increased remarkably over the last several years, claiming they offer “an easy way to get huge profits from a small investment”. As with most get rich quick schemes, this is too good to be true. The activities and conduct of said offshore firms has been formally condemned, and a joint fraud advisory was issued by the CFTC and SEC in June of 2013, alerting investors about the complaints they had received about firms making such outlandish claims. In this advisory they also explained what an investor should look for in legitimate firms offering binary options. But unfortunately, confusion still exists.

As explained in the CFTC/SEC Fraud Advisory note, Nadex (North American Derivatives Exchange) and the CME (Chicago Mercantile Exchange) are the only exchanges to legally list binary options in the United States. U.S. Exchanges are regulated by government agencies concerned with protecting traders and investors. They hold the exchanges to extremely high standards as part of this protection. The SEC and the CFTC are the two agencies responsible for maintaining a fair marketplace. Exchanges that hold member funds have strict requirements as to how this money is allowed to be handled, as part of the regulatory structure. This means that, in general, funds must be held in segregated accounts with highly stable and secure financial institutions. Moreover, when members wish to withdraw funds, the exchanges must provide a withdrawal process that is easy to understand and fast.

Regulated binary options offer transparency

Aside from general consumer protection, one of the main benefits of trading binary options on a regulated exchange is the transparency of the markets. Because determination of the prices of these contracts is derived from and settled against a 3rd party market, traders have complete transparency, and the exchange will provide time and sales data for verification to respond to any question a trader may have regarding a settlement. Basically, an exchange matches buyers and sellers in an unbiased manner. To avoid conflicts of interest, neither the exchange itself, nor its employees, may take positions in its markets. And, unlike some OTC firms, exchanges never set the prices or hedge the other side of your trade.

Exchanges must publish rules that are well established and clearly defined. Any rules that do change need to be approved by the appropriate supervising authorities and investors must be notified of the rule change before it takes effect. Some of the offshore firms do not do this, and in reality are operating as little more than glorified bookies, taking bets on where you think a price will move.

 

Capital-Protected Investments and Binary Options

Capital-Protected Investments and Binary Options

The security of an individual investor’s money is usually their primary concern, and we can often see this reflected in their investment choices. For example, a high level of capital security is guaranteed by Treasury bonds and bank deposits, while there is always a risk of loss along when investing in equities and mutual funds which can affect invested capital to a great extent. Finally, higher levels of risk are always carried by derivative products such as options and futures, as you can lose a bigger amount than that you actually invested.

 

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The concept of capital-protected investments

Lots of mutual fund firms work with the concept of “capital protection”, and some have launched capital guarantee funds, which provide an upward return potential while also guaranteeing the preservation of the invested amount. And this gets even more interesting when individual investors can merge bonds with binary options in order to similarly create their own capital-protected investment products.

U.S. Treasury bonds provide guaranteed risk-free returns. Let’s assume a one-year Treasury bond offers a 5.5% annual rate of return.

Bond returns are calculated using the formula:

Maturity Amount = Principal x (1 + Rate)^Years

For example, investing $5,000 in this bond for one year will get you a maturity amount of:

Maturity Amount = $5,000 x (1+5.5%)^1 = 5,000 x (1+0.055) = $5275.

To preserve this capital of $5,000, the above formula can be reverse engineered: “How much do I need to invest today to get $5,000 as a maturity amount after one-year?

Here, Maturity Amount = $5,000, Rate = 5.5%, Time = 1 year, and we need to find the principal.

Principal = $5,000/(1+0.055)^1 = $4739.34

Investing $4739.34 in the above bond will secure your capital, since you will get $5,000 at maturity.

Binary options as a capital-protected investment

The remaining amount, $5000 – $4739.34 = $260.66, can be used to purchase binary options, which offer high return potential. Say you believe that ABC Inc. stock currently trading at $30 has the potential to hit $55 in one year’s time. A binary call option on this stock with one year to expiry and $50 strike price is available at $37. You can purchase seven such binary options totaling $259, which fits within the available money ($260.66).

If your assumption comes true, and ABC stock reaches the strike price of $50 or higher, each of your binary option will give you a $100 payoff($700 for the seven binary options). Your total return from bond and binary option comes to ($5,000 + $700) = $5,700. On your total invested amount of around $5,000, your net percentage return comes to ($5,700 – $5,000)/$5,000*100% = 14%. In this case, your capital remains protected and you also earn returns that are significantly higher than what you could expect from a bond alone.

If you are incorrect, and ABC’s stock isn’t able to cross the strike price of $50, then you lose your option premium of $259. In this case, you lose out on the excess returns, but your capital is still preserved.

In both the cases, the capital remains protected because of the Treasury bond. The potential of an upward return comes from the binary options.

Though mutual fund firms may provide similar ready-made products, they might cost a lot and might not be suitable for an individual’s choice of investment horizon or underlying assets. Creating such capital-protected investment products offers the flexibility to go for the choice of underlying security, investment horizon, or bonds.