One of the great benefits of binary options is that you can get into spread trades where you are speculating on volatility rather than direction. In other words, you are not trying to forecast where the market will or will not go. Rather, you are trying to forecast by how much it will move.Let’s analyze how you would determine position size for both volatility long and volatility short trades.
Determining Position Size on Volatility:Long Trades.As we previously discussed, in volatility long trades you are forecasting for the underlying instrument to make a move in one direction or another. You do not care where the underlying instrument goes as long as it moves by a large enough amount for you to profit. This type of trade is also referred to as a strangle in the option trading industry.
As you just learned, your position size here is determined by your maximum loss. When making this type of trade, you would lose if the underlying does not move by a large enough amount in one direction or another.In order to determine your position size, you need to find out what this maximum loss will be.As you may recall, in order to make a volatility long trade, you need to purchase a binary option with a strike price above the market price of the underlying, and you need to sell the option with the strike price below the market price of the underlying.
For both of these trades you will need to put up collateral for the long trade. This will be equivalent to the premium of the option you are buying.And for the short trade, this will be equivalent to 100 minus the premium of the option that you are selling. If the underlying does not make a large move up or a large move down, you stand to lose both of the collaterals that you put up to enter this trade.
In order to figure out the number of contracts to trade for each leg of the spread, you will need to take the maximum single trade dollar loss that you are willing to risk on your account and divide this number by the maximum you stand to lose per contract if the underlying does not move by a large enough amount in either direction.For example, if $500 is the most you are willing to risk on one trade in your account and the maximum single trade dollar loss for both legs of the trade is $100, then you would be able to get into five contracts for each leg of your strangle.
Exhibit 14.6 depicts an option chain on US 500 binary options.So let’s assume that the S&P futures are trading at 1300 and you assume that they will make a large move in one direction or another. You decide to sell the 1280 option and buy the 1320 option to get into your strangle. The 1280 option has a premium of 80, requiring you to put up a $20 collateral. And the 1320 option has a premium of $10, requiring you to put up a $10 dollar collateral.
Let’s also assume that you have $10,000 in your trading account and you are willing to risk 3 percent on any one trade. Therefore, your maximum single trade dollar loss is $300.The total collateral that you put up to enter this trade is $30. If you are going to be holding until expiration, you will need to divide the maximum single trade loss that you are willing to accept in your account by the collateral that you have to put up per contract in order to determine how many contracts to trade for each leg.
Therefore, in this case, you will need to divide $300 by $30. This will show you that you can trade 10 contracts in this trade. This means that you buy 10 contracts of the 1280 strike price binary option and you sell 10 contracts of the 1320 strike price binary option.The main rule of thumb when trying to figure out the number of contracts to trade on positions that you plan to hold until expiration is always going to be as follows:
Divide the max single trade loss that you are willing to accept by the total max collateral per unit of the trade or for the entire spread (if you plan to be getting into a spread position).When getting into a volatility long spread with binary options, time is working against you. As expiration approaches, the time value of the option is going to decrease if the underlying does not make a drastic enough move in one direction or another.
Exhibit 14.8 depicts how an option’s time value decreases as the contract nears expiration. The y‐axis represents the time value of an option.The x‐axis represents the amount of time until the option contract expires.Options with strike prices below the market price will all start to approach $100, as they are most likely to settle in‐the‐money. And options with strike prices above the market price will start to approach $0, as they are most likely to settle out‐of‐the‐money.Exhibit 14.9 shows option chains of the US 500 binary options strike prices. Pictured left is with 20 minutes to expiration, and right is with 12 hours to expiration.