In recent articles we have examined some of the characteristics of out-of-the-money (OTM) binary options. Now we will begin to look at specific strategies that can be used to implement these OTM trades.
As an example of how to use this OTM strategy, this article will use CFTC-regulated binary options with a base value of $100 per contract. The trade shown is an illustration of how to implement this strategy and is not intended to be advice or a recommendation concerning any specific trade.
Today’s strategy is known as a trend continuation. You have likely heard the term “the trend is your friend.” At some point, the trend will become overbought or oversold, then correct before resuming its original direction.
We can see this type of movement below. On the chart, you can see that the forex currency pair GBP/USD suffered a major technical and fundamental drop on the June 23rd Brexit vote. Since then, this pair has consolidated and traded higher. However, it appears to have possibly made a near-term high and is beginning to trade lower again, continuing its original downtrend. (Clicking on the chart will enlarge the image.)
Based on this chart, it would be reasonable to expect at least a retest of the June lows of the 1.2797 area, and this could come as early as this week. This is a fine example of how OTM binary options can be used with low risk to take advantage of a calculated move.
The OTM option we will use has a weekly strike that expires at 3:00 pm EST on Friday. The strike price is 1.2925, which is about 250 pips below current price and 125 pips above the June low. Forex traders know that the GBP/USD pair, when trending, can often trade 100+ pips in a single day.
The trade is to sell this option at the bid price of $82.50. This means that the risk is the difference between that sale price and the $100 per-contract value ($100 – $82.50), or a risk of $17.50 per contract. The potential reward on this trade would be the sale price of $82.50. In other words, this trade offers nearly a 5:1 return on risk if the GBP/USD closes the week below the strike price.
Note using binary options, there are many strike choices. By just using one binary strike level higher (1.2975 strike) in this strategy would increase your probability of success by reducing the how far the GBP/USD has to retrace by 50 pips. However when your chances of success increase there is always a cost which would also increase reducing your ROI on the trade if finishing in the money.
Trend continuation is one way in which OTM options can be used to give traders with a specific market view an edge to compete. In upcoming articles we will examine other trading strategies using OTM options.
Note: Exchange fees not included in calculations.
Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.
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