Convergence Of Binary & Vanilla Options

Before moving on to consider the Nadex bull spread option in more detail, perhaps at this point it is appropriate to recap on the risk reward profiles we have considered in the book thus far.If we start with off exchange options instruments, here the risk and reward profile is capped, with returns typically ranging between 70% to 100%, but for certain products such as one touch and no touch options, these can be dramatically higher.

When we move to the on exchange world of binary options, whilst the model is still one where risk and reward are capped, the flexibility of the instrument allows us to define our own returns and manage them more directly. This facet of flexible returns is one of the key features offered by an on exchange binary option, and only available as a result of the instrument’s unique design.In the world of vanilla options, the risk and reward profile changes once again, and will also depend on whether we are a buyer or seller.

For option buyers, the risk is always limited to the premium paid with an associated unlimited profit. For option sellers, the profit is always limited to the premium received with an associated unlimited risk.You may be forgiven for thinking that option buying would seem to make perfect sense from a risk and reward perspective. But you would be wrong. It is in fact option sellers who have the probabilities and the maths on their side, and not option buyers.

There are many reasons for this, but time and in particular the wasting aspect of time is one of the biggest factors. There are others, and in a book such as this it would take too long to explain all the research and facts surrounding this apparent paradox. But take in on trust, this is the case with somewhere between 75% to 85% of vanilla options expiring worthless.

As a result vanilla options traders have developed a huge range of sophisticated and complex strategies in order to blend together the buying and selling of puts and calls to take advantage of a variety of market conditions. One such is the spread strategy, and what is perhaps both curious and apparently paradoxical is that once again we are returning to the fixed risk and fixed reward profile.

However, as with the on exchange binary option which offers increased flexibility in defining and managing the returns, here it is in the application of the option when used in conjunction with the underlying market, that its true power is revealed. The Nadex bull spread pulls together the unique aspects of a binary option, and then combines these with this tried and tested strategy borrowed from the vanilla options world.

This in turn creates an elegant, yet simple and powerful instrument, which when combined with the underlying market offers the best of both in one simple instrument.Bull Spread – Vanilla vs Nadex The construction of a spread position is one many vanilla option traders adopt. There are too many to consider here. However, what they have in common is the risk to reward profile, where the profit and the loss are capped.

As with buying calls or puts, this is considered to be a relatively conservative approach since risk is capped, which is the quid pro quo for relinquishing unlimited profits.The vertical option spread is created using vanilla options, and involves buying and selling a call option, of the same expiry, but with different strike prices. As a general rule, the bull vertical call spread is created by buying the option with the low strike price and selling the option with the high strike price – (a bear vertical spread takes the opposite approach).

These are the two legs of the option strategy which then create the following risk profile. There are, of course debits and credits here, as part of the buying and selling of the options, but for our purposes I am simply interested in explaining the risk reward profile and how this relates to the Nadex bull spread equivalent.The risk reward profile is as shown in Fig 9.14, and is the same whether you are trading a vanilla option bull call strategy or the Nadex equivalent bull spread.

The strike price of each call defines the upper and lower boundaries of profit or loss, which are both capped. If the underlying asset moves sharply higher during the life of the strategy, your profit is limited as you have given up this potential return in favor of taking a reduced risk. Your risk/reward profile is capped and defined by the spread between the two strike prices of the call along with any net debit or credit on the two legs of the options.

On the Nadex equivalent there are no debits or credits to worry about as there are no premiums to collect or pay on this instrument. It is simply the risk and reward profile that is common to both.The bull spread is just one simple example of how binary options and vanilla options are moving ever closer in terms of their risk and reward profiles.