A binary option is a bet that the vehicle will close above (long) or not above (short) the strike price. The payoff for a successful trade is $100, and the payoff for an unsuccessful trade is nothing. The net for a long is the payoff less the cost of the option. For a short, the net is revenue from selling the option.
Binary options are much like the lottery: The player either wins or losers at expiration. The differences from the lottery are that the option can be traded before expiration to mitigate a potential loss, and the options can be sold to create a short position.
My present tactical hypothesis is as follows:
Attack of the Quants
First, the implied volatility analysis is of some use.
| Week | SD1 68.2% | Strike: Bid/Ask |
|---|---|---|
| Upper | 2131.38 | 2130: 13.75/16.25 |
| Lower | 2120.76 | 2121: 61.75/66.00 |
My working assumption is that I would go short the upper strike, producing a pay-off at the close at 4:15 p.m. New York time is the inverse of the bid/ask, or long the lower strike, where the payoff is based directly on the bid/ask.
This gives me a risk/reward ratio of 1.2:1 for the short upper strike, and a ratio of 1.5:1 for the long lower strike.
These are acceptable levels of risk and reward for my stock options trades, and ought to be acceptable here as well.
Charts matter
Second, the best statistics in the world can be overthrown by chaos, and markets are often chaotic. By chaotic, I mean non-trending.
So my tactics need to include an assessment of the chart. For that, I bring in Elliott wave analysis, a technique I used for several years in my stock options trading.
Click on chart to enlarge.
 |
| SPX at 1 p.m. New York time, 3 days 5-minute bars |
Tactically, the chart argues against opening a binary option on SPX. But if I were to throw cauton to the winds, I would want to go short the 2130 strike, or perhaps the 2127 strike, the latter being above the upper boundary of the triangle.
Casino exit vs. managed exit
There is a third question that I don't yet have a good answer to: Which is the best exit strategy, the casino approach or the managed exit?
By the casino approach, I mean placing the trade and holding it until expiration under all circumstances. This avoids whipsaws, where a stop/loss triggers and exit but the price reverses, making the exit unnecessary in retrospect.
A managed exit approach watches the chart and exits if the trend turns against the position. This mitigates losses, but produces whipsaws.
A Real Trade
Of course, my goal in all of this is to learn how to best trade binary options. And I don't learn if I don't trade.
So, I've opened a bear position on SPX, as follows
S&P 500 (US 500) Daily Binary
sold May 20 at 1:45 p.m. New York time for a credit
and expiring May 20 at 4:15 p.m.
With the price at $2,125.01, implied volatility stands at 13.0% with 120 minutes remaining before expiration.
| Week | SD1 68.2% | SD2 95% |
|---|---|---|
| Upper | 2,129.18 | 2,133.36 |
| Lower | 2,120.94 | 2,116.66 |
The premium is $23.50, and the risk/reward ratio is 4.3:1, about what I would expect with a short vertical options spread on a stock.
I shall use the casino method for my exit rule. (See my discussion above.)
Result
Shares rose by 0.16% during the 4-1/2 hour lifespan of the position, or a -548% annual rate. The binary options position produced a 23.5% yield on debit, for a +81,261% annual rate.
Bad news: My entire theory of the chart was blown away by reality. Before closing profitably, the price rose well above its May 19 high, to $2,134.72, and then dropped below my strike price 55 minutes before the close. The rise coincided with release of the Federal Open Market Committee minutes, raising the question of whether I should account for economic releases in my strategy.
Good news: Had I been doing a managed exit, I would have closed the position for a loss 12 minutes after entering, but I was doing the casino exit, which means I was still in the postion when it became profitable again.
Note I'm experimenting with binary options on the Nadex platform (www.nadex.com). I don't have a full rule-set developed as yet, but generally I'm applying the same techniques that I use for my volatility plays on stocks and their options. If I can satisfy myself that I can create an edge in these sorts of trades, I'll add it to my collection of strategies.
-- Tim Bovee, Portland, Oregon, May 20, 2015
References
My volatility trading rules can be read here.
Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.
Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.
See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.
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Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.License
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Based on a work at www.timbovee.com.
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