Another great benefit of binary options is that you can profit by speculating on market ranges. These are called volatility short spreads, and you essentially profit as long as the underlying stays within a certain range.This position is often referred to as the short strangle in the options industry. When getting into this trade, you would purchase an option with the strike price that is below the market price of the underlying, and you would sell an option with a strike price that is above the market price of the underlying.
With this trade, you profit as long as the underlying does not fall below the long option’s strike price and does not rise above the short option’s strike price.One nice aspect of this trade is that one of the legs of this trade is always going to win. The reason for this is that the underlying cannot be above the upper (short) options and below the lower (long) at expiration.Let’s look at a simple example to drive this concept home.
Let’s assume that the S&P futures are trading at 1300, and you purchase a 1280 option and sell a 1320 option. The S&P futures cannot be above below 1280 and above 1320 at the same time.Exhibit 14.11 depicts the profit and loss (P&L) of going long a binary option and short a binary option. The x‐axis represents the price of the underlying,and the y‐axis represents the P&L.
If at expiration the underlying has closed below the short position and/or above long position, the trader will profit.For this reason, your maximum risk on this type of trade is not the combined collateral of the two legs. Instead, it is the combined collateral of the two legs minus 100. The reason for this is that even though you will lose your collateral on one leg of the trade, you will still always get $100 in settlement per contract on the other leg of the trade.The way you would calculate position size for this type of trade is the same as you would for all trades.
You would divide your maximum allowable single trade loss for the entire account by the maximum single trade loss that you could expect to get per unit of the entire spread.Here is a step‐by‐step breakdown of how you would determine the position size using the 2 percent rule for a binary options short volatility spread.
Step 1: Determine the maximum loss that you would be willing to take on your trading account. This is done by simply multiplying your Risk Management 197 account balance by the maximum percentage that you are willing to lose. Let’s assume 2 percent here.
Step 2: Find the maximum single trade loss per one unit of the entire
spread. For this you would need to determine the collateral for both legs of the spread and then simply subtract one hundred.
Step 3: Divide the maximum loss from step 1 by the maximum loss per unit from step 2.Once you get this figure, you know how many spread positions you can put on in the account. Please keep in mind that each volatility short spread position has two trades, not one. Therefore, if you determine that you can get into six units of the trade, that means that you can buy six of the option below the market price and sell six of the binary options above the market price.Rationale Assumption:
You have $10,000 in your account and you are willing to risk 2 percent ($200) on any one trade. The S&P futures are trading at 1300, and you believe that they will stay in a range this week between 1320 and 1280.Trade Breakdown You decide to enter a volatility short spread by buying the 1280 in the money binary option and selling the 1320 out-of-themoney binary option.
The 1280 option has a premium of $80, and the 1320 option has the premium of $10. Please note that although the strike prices are equidistant from the market price, the option premiums are different. The reason for this is that binary options are traded on the open market and their prices are determined based on the perceptions of the participating traders and market makers.
Therefore, the collateral that you would have to put up for the long inthe‐money positions is simply the $80 premium, and the collateral that you would have to put up for the short out‐of‐the‐money position is $100 minus
the $10 premium or $90.With binary options you still have to put up the collateral for both legs, so you would need $170 ($90 for the short trade plus $80 for the long trade) to enter the spread. However, your maximum loss is only $70 since there is no possible way that you can lose on both legs of the spread at expiration.