Settlement of short binary options trades is a bit trickier than settlement of long trades. But if you keep the basic principle of $100 per contract if you are correct and $0 per contract if you are wrong, you should be able to pick
up the concept pretty quickly.In order to have an understanding of how short binary option trades are settled, you must have a clear understanding of how short binary option trades work and how they are collateralized.
If you need further clarification on these concepts, please refer to the section on collateral.As you will recall from the section on collateral, when you sell a binary options contract, you put up the full collateral. Full collateral means that you are putting up your maximum potential loss to enter your trade.
The formula for maximum loss is:$100 – Option Premium = Maximum Loss on Short Trade In a short trade your maximum potential loss per contract is $100 minus the option’s premium.Remember, the value of a contract goes to $100 at expiration if the underlying is trading above the strike price. For example, let’s assume that you are selling a binary option for $40.
The most you can lose when that option expires is $60.Exhibit 5.8 is a graphical representation of the profit and loss on a short position. In this example the required collateral and maximum loss (dark grey shaded area) is $60, which is calculated by subtracting 100 from the option premium ($40).
The maximum potential profit (light grey shaded area) is simply the option’s premium, in this case $40.If you are correct on your binary options short trade and the underlying does close below your strike price, then at trade settlement you will receive $100 per contract revenue. If you subtract the collateral that you put up from the $100, it will equate to the options premium.Here is a simple formula to demonstrate this:1:Profit = $100 – Collateral 2:Collateral = $100 – Premium 3:Profit = $100 – ($100 – Premium)4:Therefore:Profit = Premium
For example, if the S&P futures are trading at 1280, you may be able to sell a “> 1290” contract for $30. You will have to put up $70 per contract in collateral for this. If you decide to stay in your trade until expiration and the S&P futures close above 1290, you will lose your $70/contract collateral and end up with nothing.However, if the S&P futures close below 1290 at expiration and you stay in your trade until expiration, your trade will settle at $100/contract to you.
Your account will be credited $100/contract shortly after expiration and you will receive a notification e‐mail. Your total profit per contract on the trade will be the $100 settlement minus the original $70 collateral that you put up. This equates to the $30 option premium of the “> 1290”contract.Exhibit 5.9 depicts the P&L of going short one contract of the 1290 US 500 binary option. The x‐axis represents the price of the underlying, and the y‐axis represents profit and loss.