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Binary Options Trading System Using Call and Put Positions
This lens introduces a binary options trading system which will demonstrate how to mitigate some of the risks associated with these highly powerful investment trades. It will also demonstrate the characteristics and usefulness of these contracts and provide some insight as to how to use them to augment portfolio returns.
Contents at a Glance
Binary Options Trading System Introduction
The Basic Payout Structure of a Binary Options Contract
First and foremost all images and examples were developed by and used with permission of binary-option-broker.com. Trading binary options requires the use of a specialist trading firm called a binary option broker. There are numerous uses of binary options trading described in further detail elsewhere. It also really helps to have a good feel for basic options trading market economics.
With that out of the way, the most important thing to understand about this binary options trading strategy is that it is designed to help traders both understand the nature of these great contracts: to understand the strengths of using them, and to prepare for and mitigate some of their weaknesses. First I'd like to show you the basic payout structure of a binary options contract, in this case, a call option (see glossary of binary options trading terms).
A Binary Call Option
An Open or Un-Hedged Binary Call Option Payout Example
In this example you see the payout characteristics of a $200 binary call option with 75% yield on in the money contracts and 15% return of capital on out of the money contracts. Note that an in the money contract pays $350 ($200 initial investment plus $150 profit), an out of the money contract pays $30 ($200 x 15%), and an at the money contract pays $200 (initial investment amount).
Most people would not be happy with this sort of "all or nothing" investment structure, yet nonetheless some traders do in fact use binary options trading systems that involve unhedged positions like this. We however are going to attempt to demonstrate how to mitigate the weaknesses of the out of the money position... by adding an equal and opposite put binary options contract on the same security.
Developing a Binary Options Hedge
Using a Put Option to Hedge an In the Money Call Option
As you might imagine, a binary options put contract has the exact opposite payout structure of the binary options call contract we discussed earlier. In other words when the stock price at expiration is less than the strike price on the binary options put contract, the binary put expires in the money and the payout (assuming the same characteristics as in our previous example) is $350. Similarly, an out of the money contract would pay $30 and an at the money contract would pay $200.
How would we combine the two contracts to create a hedged position which might be of benefit to the trader? Well this is where the details of the trades matter. In order for a call option to be in the money, the stock price must be higher than the strike price at expiration, right? Well what if during the term of the contract (after purchase but before expiration) the stock price had in fact moved upward, say from $577.50 (in our illustrated example above) up to $579? At that point our binary call would be in the money, wouldn't it?
What if then we decides to buy a $200 put option at that moment (when stock price is $579)? What would the payout structure look like?
A Hedged Binary Options Trading System Payout Example
The Payout Structure of a Combined Binary Option Call with Put Contracts
You'll note in the picture above that we've not boxed in an area between share prices of $577.50 per share and $579 per share where BOTH the binary call option AND the binary put option are in the money and yield 75%. This produces a payout structure where the (now 2) initial investments of $200 (one call followed by one put) EACH payout $350 (each pays out $200 initial investment plus $150 profit), for a total cash flow of $700 ($400 initial investment plus $300 profit).
In the case where the stock price at expiration is anywhere outside the range of $577.50 to $579, one of the contracts expires out of the money. In this case one contract is in the money (paying $350), one contract is out of the money (paying $30) for a net payment of $380 - a loss of 5%. In the odd case where the stock price at expiration is either exactly $577.50 OR exactly $579, one option expires at the money (paying $200) while the other contract expires in the money (paying $350) for a net cash flow of $550, a profit of 37.5%.
Summary
A Synopsis of This Binary Options Trading Strategy
This binary options trading strategy was design to demonstrate how to take advantage of the strengths of binary options contracts while also mitigating some of the weaknesses. This is but one potential means of using binary options contracts.
See other video demonstrations of binary options trading systems.
Questions About This Binary Options Trading System?
Leave Questions or Comments About Binary Options Trading Systems
We love to hear from our readers, and take our reader's questions and turn them into future posts on our options trading blog.
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gosmart
Oct 21, 2011 @ 9:43 am | delete
- Great system when it applies but what if after the call option the price goes down?
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optiontradingtutorial
Oct 21, 2011 @ 12:56 pm | delete
- You have two options if the market moves opposite: you can close off your position quickly guaranteeing a high likelihood of small loss (5% in our example with a tiny % chance of large loss) or you can ride it out unhedged.
Either way - it is IMPERATIVE that you get the initial direction right. If you can get the initial direction right and can close off the hedge you only have to be correct on BOTH contracts a TINY percentage of the time to be very profitable.
I hope that answers your question.
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gosmart
Oct 22, 2011 @ 1:40 pm | delete
- Thank :)
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