The Simple Math of Multi-Leg Binary Option Trades
Tommy O’Brien / TFNN
The new and growing world of binary options has introduced many traders to an entirely new way to trade indices, commodities, and currencies on a variety of time frames. When you first are exposed to the binary option market, most traders see things as they are on the surface, with two possible outcomes of either success or failure with each trade. However using multi-leg binary option trades to profit from non-directional moves in the market is another way to trade these exciting new products. While at first the idea of trading multiple binary options on both sides of the same underlying product may seem complicated, the math becomes very easy once you become accustomed to the risk vs. reward components involved.
Binary options have two possible outcomes, they either expire in-the-money for full value or expire out-of-the-money for no value, hence the name ‘binary’. On the Nadex Exchange binary options are worth $100 per contract at settlement if they expire in-the-money. Prior to expiration, each binary option will be quoted anywhere from 0 - 100, depending on the perceived probability of that binary option expiring in-the-money. If market place perceives that there is greater than a 50% chance that the binary option will expire in-the-money, then the binary quote will be quoted above $50. Inversely, if the market place perceives that they binary option has less than a 50% chance of finishing in the money than the binary quote will be below $50.
Here is a chart of the Gold contract on the NADEX Exchange, which is based off the COMEX/NYSE® April Futures contract.
This chart is from Tuesday March 7th at about 12 noon ET. Along the right hand axis are some of the daily binary options available, which expire for Gold at 1:30 p.m. ET leaving 90 minutes. As you can see there are a variety of strike prices with varying bid/offer quotes which reflect the perceived likelihood of those binary options expiring in-the-money in terms of the binary buyer.
After moving lower during the early morning pre-market trading it looks like Gold could be building a base around the $1,217.50 price level to the lower end, and potentially $1,220.50 to the upside where it tested during the 10 0’clock hour before failing and trading lower.
With a potential trading range for Gold of $3, what kind of a trade strategy could you assemble if you thought that Gold would close between these two price levels by 1:30 p.m. ET on March 7th?
If you chose to buy the >$1,217.50 binary option at $60.75 you would be risking that $60.75 for a potential profit of $39.25 if the underlying Gold contract expires above that strike price as of 1:30 p.m. ET on March 7th. You could also simultaneously choose to sell the >$1,220 binary option at $10.75. When selling a binary option your risk is that the binary settles at 100, not zero where you would be risking $89.25 for a maximum profit of $10.75.
Combined this strategy has a total initiate cost of $150 ($60.75 + $89.25) for both legs however keep in mind the crucial part of this strategy is that it is impossible for both binary positions to expire worthless.
The price of gold is guaranteed to either close above $1,217.50 or below $1,220.50 with the possibility of doing both. Thus you are guaranteed to receive $100 back at settlement on at least one contract expiring in-the-money, which decreases your actual overall risk to only $50. Considering you stand to make $50 in this example if Gold closes within the $3 trading range you’re looking at a 1:1 risk vs. reward set up for this theoretical trade.
Regardless of how the risk vs. reward of the trade sets up, which can depend on a variety of factors including volatility and time to just name a couple, this is an example of how easily you can use multiple binary option trades to set-up simple trading positions that can more accurately benefit from your market expectation.
Now, let’s look at the exact opposite trade. What if you thought Gold was poised to break out of its range today by the 1:30 p.m. ET expiration? If you chose to buy the >$1,220.50 binary option for $15.75 you would be risking $15.75 for a maximum profit of $84.25 ($100-$15.75). You could then simultaneously sell the $1,217.50 binary option at $54.75, risking $45.25. For this multi-leg binary option trade you would have a combined trade risk of $61 for a potential profit of $39 if either contract expired in-the-money, with Gold closing above $1,220.50 or at or below $1,217.50 as of 1:30 p.m. ET on March 7th.
If you don’t like trading directionally then binary options can be a great way to trade volatility regardless of what direction the underlying product moves. You can try using this same multi-leg strategy on almost any binary option market offered on the Nadex Exchange. Many times traders like to look for volatility trades prior to news events such as earnings, Non-Farm Payroll, or the EIA Crude Oil Inventory Report just to name a few , but they can be just as profitable without expected news on the horizon.
Use the examples in this article to allow yourself to think more about the set-up of trades before you put your money at risk, and how you may be able to shift that risk vs. reward potential to increase your trading results. Instinctively, when we hear the word ‘binary’ we think of 2 possible outcomes. Change the way you think about binary options, and you may be able to increase your profitability dramatically by shifting your methodology only slightly.
Note: Exchange fees excluded for calculations.
Nadex Risk Disclaimer
- Trading on Nadex involves financial risk and may not be appropriate for all investors. The information presented here is for information and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Any trading decisions that you make are solely your responsibility. Past performance is not indicative of future results. Nadex instruments include forex, stock indexes, commodity futures, and economic events.
- Nadex binary options and spreads can be volatile and investors risk losing their investment on any given transaction. However, the limited-risk nature of Nadex contracts ensures investors cannot lose more than the cost to enter the transaction. Nadex is subject to U.S. regulatory oversight by the CFTC.