Understanding a Straddle Strategy For Market Profits

Randy

In trading, there are numerous sophisticated trading strategies designed to help traders succeed regardless of whether the market moves up or down. Some of the more sophisticated strategies, such as iron condors and iron butterflies, are legendary in the world of options. They require complex buying and selling of multiple options at various strike prices. The end result is to make sure a trader is able to profit no matter where the underlying price of the stock, currency, or commodity ends up.

However, one of the least sophisticated options strategies can accomplish the same market-neutral objective and with a lot less hassle. The strategy is known as a straddle. It only requires the purchase or sale of one put and one call to become activated. In this article, we’ll take a look at the types of straddles and the benefits and pitfalls of each.

Key Takeaways

An options straddle involves buying (or selling) both a call and a put with the same strike price and expiration on the same underlying asset.A long straddle pays off when volatility increases and the price of the underlying moves by a large amount, but it doesn’t matter whether it’s to the upside or the downside.A short straddle pays off when there is low volatility and the price of the underlying at expiration has not moved much from the straddle’s strike price.

Types of Straddles

A straddle is a strategy accomplished by holding an equal number of puts and calls with the same strike price and expiration dates. The following are the two types of straddle positions.

Long Straddle—The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date. The long straddle is meant to take advantage of the market price change by exploiting increased volatility. Regardless of which direction the market’s price moves, a long straddle position will have you positioned to take advantage of it.
Short Straddle—The short straddle requires the trader to sell both a put and a call option at the same strike price and expiration date. By selling the options, a trader is able to collect the premium as a profit. A trader only thrives when a short straddle is in a market with little or no volatility. The opportunity to profit will be based 100% on the market’s lack of ability to move up or down. If the market develops a bias either way, then the total premium collected is in jeopardy.

The success or failure of any straddle is based on the natural limitations that options inherently have along with the market’s overall momentum.

The Long Straddle

A long straddle is specially designed to assist a trader to catch profits no matter where the market decides to go. There are three directions a market may move: up, down, or sideways. When the market is moving sideways, it’s difficult to know whether it will break to the upside or downside. To successfully prepare for the market’s breakout, there is one of two choices available:

The trader can pick a side and hope the market breaks in that direction.
The trader can hedge their bets and pick both sides simultaneously. That’s where the long straddle comes in.

By purchasing a put and a call, the trader is able to catch the market’s move regardless of its direction. If the market moves up, the call is there; if the market moves down, the put is there. In Figure 1, we look at a 17-day snapshot of the euro market. This snapshot finds the euro stuck between $1.5660 and $1.54.

Image by Sabrina Jiang © Investopedia 2020

While the market looks like it may break through the $1.5660 price, there is no guarantee it will. Based on this uncertainty, purchasing a straddle will allow us to catch the market if it breaks to the upside or if it heads back down to the $1.54 level. This allows the trader to avoid any surprises.

Drawbacks to the Long Straddle

The following are the three key drawbacks to the long straddle.

The rule of thumb when it comes to purchasing options is in-the-money and at-the-money options are more expensive than out-of-the-money options. Each at-the-money option can be worth a few thousand dollars. So while the original intent is to be able to catch the market’s move, the cost to do so may not match the amount at risk.

In the figure below, we see the market breaks to the upside, straight through $1.5660.

ATM Straddle (At-The-Money) 

Image by Sabrina Jiang © Investopedia 2020

This leads us to the second problem: the risk of loss. While our call at $1.5660 has now moved in the money and increased in value in the process, the $1.5660 put has now decreased in value because it has now moved farther out of the money. How quickly a trader can exit the losing side of the straddle will have a significant impact on what the overall profitable outcome of the straddle can be. If the option losses mount quicker than the option gains or the market fails to move enough to make up for the losses, the overall trade will be a loser.

The final drawback deals with the inherent makeup of options. All options are comprised of the following two values:

Time value—The time value comes from how far the option is from expiring.
Intrinsic value—The intrinsic value comes from the option’s strike price being out, in, or at the money.

If the market lacks volatility and does not move up or down, both the put and call option will lose value every day. This will go on until the market either definitively chooses a direction or the options expire worthless.

The Short Straddle

The short straddle’s strength is also its drawback. Instead of purchasing a put and a call, a put and a call are sold in order to generate income from the premiums. The thousands spent by the put and call buyers actually fill your account. This can be a great boon for any trader. The downside, however, is that when you sell an option you expose yourself to unlimited risk.

As long as the market does not move up or down in price, the short straddle trader is perfectly fine. The optimum profitable scenario involves the erosion of both the time value and the intrinsic value of the put and call options. In the event the market does pick a direction, the trader not only has to pay for any losses that accrue, but they must also give back the premium they have collected.

The only recourse short straddle traders have is to buy back the options they sold when the value justifies doing so. This can occur anytime during the life cycle of a trade. If this is not done, the only choice is to hold on until expiration.

When Straddles Strategy Works Best

The option straddle works best when it meets at least one of these three criteria:

The market is in a sideways pattern.There is pending news, earnings, or another announcement.Analysts have extensive predictions on a particular announcement.

Analysts can have a tremendous impact on how the market reacts before an announcement is ever made. Prior to any earnings decision or governmental announcement, analysts do their best to predict what the exact value of the announcement will be. Analysts may make estimates weeks in advance of the actual announcement, which inadvertently forces the market to move up or down. Whether the prediction is right or wrong is secondary to how the market reacts and whether your straddle will be profitable.

After the actual numbers are released, the market has one of two ways to react: The analysts’ prediction can add either to or decrease the momentum of the actual price once the announcement is made. In other words, it will proceed in the direction of what the analyst predicted or it will show signs of fatigue. A properly created straddle, short or long, can successfully take advantage of just this type of market scenario. The difficulty occurs in knowing when to use a short or a long straddle. This can only be determined when the market will move counter to the news and when the news will simply add to the momentum of the market’s direction.

The Bottom Line

There is constant pressure on traders to choose to buy or sell, collect premium or pay premiums, but the straddle is the great equalizer. The straddle allows a trader to let the market decide where it wants to go. The classic trading adage is “the trend is your friend.” Take advantage of one of the few times you are allowed to be in two places at once with both a put and a call.

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The 7 Biggest Canadian Energy Companies (IMO.TO, TRP)

Randy

Canada was the world’s fourth-largest producer of oil in 2020 and the fifth-largest producer of natural gas, according to the U.S. Energy Information Administration. It is not surprising that energy firms dominate the ranks of the biggest Canadian energy companies. Each of the top seven companies had a market capitalization above $10 billion.

1. Enbridge Inc.

Enbridge Inc. (NYSE: ENB, TSX: ENB.TO) had a market capitalization of $81.9 billion U.S. dollars ($102.6 billion Canadian) as of November 2021. Enbridge is the largest energy company in Canada, but it focuses on transporting rather than producing energy. Enbridge’s businesses include oil pipelines, natural gas distribution, and alternative energy.

2. Canadian Natural Resources

Canadian Natural Resources Ltd. (NYSE: CNQ, TSX: CNQ.TO) is an exploration and production company with crude oil and natural gas operations in Western Canada and crude oil operations in offshore African waters and the North Sea. In late 2021, Canadian Natural Resources had a market capitalization of $49 billion U.S. dollars ($61.4 billion Canadian).

3. TC Energy Corporation

TC Pipeline & Energy Corporation (NYSE: TRP, TSX: TRP.TO), which was formerly known as TransCanada, is an energy conglomerate with operations in energy infrastructure and power generation. Its extensive oil and natural gas pipeline operations stretch across Canada and the U.S. It had a market capitalization of $48.5 billion U.S. dollars ($60.8 billion Canadian) as of November 2021.

4. Suncor Energy Inc.

Suncor Energy Inc. (NYSE: SU, TSX: SU.TO) is an integrated oil and gas company with operations across Canada and in the United States. The company’s Canadian oil sands properties deliver the lion’s share of its annual production. In 2021, Suncor was Canada’s fourth-largest energy company with a market capitalization of $37.5 billion U.S. dollars ($47 billion Canadian).

5. Cenovus Energy

Cenovus Energy, Inc. (NYSE: CVE, TSX: CVE.TO) is another large integrated energy company with oil and gas exploration operations. The firm is also involved in oil production and refining. In addition to conventional oil and natural gas properties, the company has substantial oil sands holdings, which expanded when the Cenovus bought out the 50% stake of ConocoPhillips in 2017. The company had a market capitalization of $25.2 billion U.S. dollars ($31.6 billion Canadian) as of November 2021.

6. Imperial Oil

Imperial Oil Ltd. (IMO; TSX: IMO.TO) is an integrated oil and gas giant. In addition to refining and petrochemical operations, the company also markets fuel, lubricants, and other products under the Esso and Mobil brands. Imperial Oil has a market capitalization of about $24.6 billion U.S. dollars ($30.8 billion Canadian)

7. Pembina Pipeline Corporation

Pembina Pipeline Corporation (NYSE: PBA, TSX: PPL.TO) had a market capitalization of about $23 billion U.S. dollars ($28.8 billion Canadian) on November 2021. The company has three divisions focusing on pipelines, processing, and new ventures. Pembina began operations in 1997, and its headquarters in Calgary supports a focus on Western Canada.

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Major Players in the 2008 Financial Crisis: Where Are They Now?

Randy

Take a look at some of the principal players during the 2008 financial crisis and ensuing meltdown to find out how they fared in the years following the crisis. Review what these key players were doing as the financial markets succumbed to chaos, and where they were on the 10-year anniversary of the event.

Treasury Secretary Henry Paulson

During the last year of the Bush administration, Henry “Hank” Paulson had a huge impact on economic policy. He was CEO at Goldman Sachs prior to his stint at the Treasury Department, which started in 2006. One of his famous decisions as secretary was to let Lehman Brothers fail, precipitating a stock market drop of nearly five percent. In his zeal not to repeat that mistake, he helped push the bank bailout through Congress.

In 2010, Paulson published the book Brink, chronicling his experiences and observations during the financial crisis.

In 2011, Paulson founded the Paulson Institute, a center based at the University of Chicago that focuses on environmental and economic policies in the United States and China. He is the chair of the institute, and he is also co-chair of the Risky Business Project, which explores the economic impacts of climate change.

Paulson was featured in the 2018 HBO documentary, Panic: The Untold Story of the Financial Crisis.

Federal Reserve Chair Ben Bernanke

At the helm of the country’s leading monetary policy-making body during the financial crisis, Bernanke was the face of quantitative easing. This policy involved reducing interest rates and injecting more money into the economy in order to encourage banks to lend and consumers to spend. While many politicians and economists were worried quantitative easing would spur inflation and new asset bubbles, some, including Nobel Prize-winning economist Paul Krugman laud Bernanke’s efforts, and even insist that he helped rein in the crisis, preventing an even bigger financial catastrophe.

Bernanke was a member of the Federal Reserve Board of Governors from 2002-2005 and served as Fed chairman from 2006-2014, when he was succeeded by Janet Yellen.

Today, Bernanke is a distinguished fellow at the Brookings Institution, and frequently blogs and gives analysis and commentary on economic policy. In 2015, Bernanke published a book, The Courage to Act, describing his experiences during the financial crisis. He became a member of the National Academy of Sciences in 2021.

N.Y. Fed Chair Timothy Geithner

When Lehman collapsed, Geithner was in charge of the most powerful branch of the Federal Reserve. A few months later, he became Treasury Secretary under President Barack Obama. On one hand, Wall Street decried him as someone who over-regulated, while on the other hand, progressive activists viewed him as a tool of the banks. During his time at Treasury, Geithner was also embroiled in a controversy over his failure to fully report and pay income tax from 2001 to 2004. Geithner apologized for the mistake and paid the IRS his outstanding debt.

Now president of Warburg Pincus, a private equity firm that runs “loans by mail” outfit Mariner Finance that makes money from short-term, high-interest loans.

Since 2014, Geithner is the managing director of private equity firm Warburg Pincus. He also occasionally lectures at Yale University’s school of management.

Lehman Brothers CEO Richard Fuld

As the last CEO of Lehman Brothers, Richard “Dick” Fuld’s name was synonymous with the financial crisis. He steered Lehman into subprime mortgages and made the investment bank one of the leaders in packaging the debt into bonds that were then sold to investors. While other banks were bailed out, Lehman was allowed to fail, in spite of Fuld’s pleas to policymakers.

Fuld claims he never received a golden parachute at his exit from Lehman, but he did make more than $466 million during his tenure. Today, Fuld maintains a low-key public profile, but he is the head of Matrix Private Capital Group, a high-end wealth management firm he helped found in 2016. 

Morgan Stanley CEO John Mack

After Lehman Brothers collapsed, Mack feared Morgan Stanley would be next, and he fought with Paulson, Bernanke, and Geithner so secure a bailout, while at the same trying to get financing from investors in Japan and China. In the end, he stood up to the policymakers, and Morgan Stanley was allowed to become a banking holding company, opening the way for increased liquidity and the opportunity to be part of the bailout.

Mack stepped down as CEO in 2010, and in 2012 relinquished his position as chair of the board. Recently, Mack has been involved as a board member with fin-tech companies such as LendingClub and Lantern Credit, where he is chair of the board. He also serves as a senior advisor to the private equity firm KKR.

Goldman Sachs CEO Lloyd Blankfein

Another investment bank that participated in packaging toxic mortgage debt into securities, Goldman Sachs, led by Lloyd Blankfein, was allowed to convert to a banking holding company and received $10 billion in government funds, which it eventually repaid. In 2009, Blankfein even apologized for the firm’s role in the meltdown.

Blankfein is one of the few players in the crisis who retained his position. Blankfein served as CEO of Goldman from 2006-2018; in 2019 he became senior chairman of the board.

JPMorgan Chase CEO Jamie Dimon

Under the leadership of Dimon, JPMorgan bought Bear Stearns and Washington Mutual in an attempt to stem the rising tide of economic instability. JPMorgan Chase took millions from the Fed’s TARP program, although in later years Dimon insisted that the company didn’t need it and they only agreed to move forward under duress from policymakers.

Like Blankfein, Dimon has managed to hold onto the reins of his company. In fact, JPMorgan, after dealing with legal issues arising from crisis-era purchases, is doing quite well. Dimon is still the CEO.

Bank of America CEO Ken Lewis

Shortly after claiming Bank of America wasn’t interested in major acquisitions, Lewis presided over its crisis-era takeovers of Countrywide Financial and Merrill Lynch. In the following months, Lewis was transformed from one of the saviors of the crisis – even receiving Banker of the Year in 2008 – into one of its villains. Bank of America almost buckled under the weight of losses from the acquisitions and Lewis himself was investigated for the methods used to gain approval for the Merrill Lynch deal.

Today, Lewis is largely out of the public eye. He agreed to pay $10 million to settle an investigation by the State of New York and even had to sell one of his multi-million dollar homes. However, Lewis also still has enough left over to endow a chair at his alma mater, Georgia State University.

President of S&P Kathleen Corbet

While other rating agencies followed similar practices to Standard & Poor’s in the run-up to the crisis, Corbet was the most high profile of the agency leaders. Time Magazine named her one of the top 25 people to blame for the financial crisis. Critics contend that Standard & Poor’s had a conflict of interest in taking payment from companies to rate the riskiness of their products.

Even though she left Standard & Poor’s in disgrace – and the company later had to pay a $1.5 billion fine to the U.S. government – Corbet has continued to serve on boards of various companies. Currently, she is the principal of Cross Ridge Capital, a firm she established in 2008, and a director of MassMutual. She also continues to consult in the fin-tech sector.

President George W. Bush

It’s debatable how much power a president actually has over the economy and the markets. However, the fact that Bush was president during the lead up to the financial crisis and the Great Recession makes him a major player. The tax cuts and deficit-spending favored by his administration didn’t help the country’s situation. There is a case to be made, though, that many of the economic problems leading to the financial crisis began during previous administrations and then-president Bill Clinton’s decision to sign a repeal of the Glass-Steagall legislation, which separated commercial and investment banking, also contributed.

Today, Bush keeps a low profile, mainly resurfacing for high-profile public events like Senator John McCain’s funeral. He spends much of his time at his home in Texas, refining his painting skills.

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3 Reasons to Use an Employer-Sponsored Retirement Plan

Randy

Although many will agree that saving for retirement is an excellent financial move, a significant number of employees still do not participate in their employer-sponsored retirement plans. The lack of participation can be the result of having insufficient income to make retirement contributions. However, many times, employees don’t participate because they’re unaware of the benefits and rules of these plans.

Below, we’ll look at some of the advantages of making salary-deferral contributions to employer-sponsored plans, such as 401(k)s and 403(b)s.

Key Takeaways

Many employees don’t participate in employer-sponsored retirement plans due to a lack of funds, or they’re unaware of the benefits.Employees who do participate benefit from lower taxable income, tax-deferred earnings growth, and deferred taxes.Many employers offer an employer-match in which they match a small percentage of what an employee contributes to the plan.

1. It Reduces Your Taxable Income

Contributions to your employer-sponsored plan are usually made on a tax-deferred basis. Tax-deferred means that your taxable income for the year is reduced by the amount you contribute to the plan. For example, say that your tax filing status is “single” and your taxable income for the year is $31,000. If you contribute $2,000 to your 401(k) account, your taxable income will be reduced to $29,000, and the amount of taxes you owe will also be reduced.

Of course, you’ll eventually get taxed on the money when you withdraw it in retirement. However, you’re likely to be in a lower tax bracket as a retiree, meaning you’ll pay less tax on the $2,000 than you would’ve paid, had you not chosen to defer it to your retirement account.

In 2020 and 2021, the annual contribution limit—mandated by the Internal Revenue Service (IRS)—for employees who participate in a 401(k) plan is $19,500. If you are aged 50 or older, you can make an additional catch-up contribution of $6,500 for both 2020 and 2021. For 2022, those contribution limits increase to $20,500 for a 401(k), with the catch-up limit remaining $6,500.

Salary deferral contributions to non-IRA based plans, including designated Roth Accounts, can also be made on an after-tax basis. In such cases, these contributions do not reduce your taxable income.

2. It Earns Tax-Deferred and Defer Income Taxes

Another benefit of saving with a tax-deferred retirement plan is that the earnings on investments are also tax-deferred. In other words, you will not pay taxes on your earnings or investment gains over the years, regardless of their value, until you make a withdrawal from the plan. Therefore, you have some control over when you pay taxes on those earnings, which in turn could affect how much income tax you pay.

For instance, you can choose to make withdrawals in years when your income is lower, which may mean, again, that you’re in a lower tax bracket. On the other hand, if you chose to invest the amount in an account that is not tax-deferred, you would owe taxes on the earnings the year the earnings are accrued.

Consider Your Total Income

The amount withdrawn from a plan on a yearly basis will determine, in part, which tax bracket you’ll fall into in retirement. It’s important to consider other income sources, such as Social Security income when deciding how much you want to withdraw from an IRA. Your total income, including the IRA withdrawal, will determine your overall tax rate for that year.

Distributions and Withdrawals

An individual is allowed to make withdrawals from a qualified plan, as long as they meet certain requirements, as defined under the plan. For example, a participant must be over the age of 59½ to begin withdrawing distributions from a 401(k). If a distribution is taken before the age of 59½, there will be penalties, including a 10% tax by the IRS on the amount distributed. Also, the distribution will count as taxable income, meaning it’ll be taxed at the employee’s marginal tax rate or income tax rate.

Also, after the age of 72, you must begin distributing funds annually from the 401(k), which are called required minimum distributions (RMDs). However, the amount of the RMD is calculated by the IRS, based in part, on the total amount of your retirement savings.

All of these factors need to be considered before determining the amount to distribute from a 401(k) plan. It’s best to consult a tax planning or financial planning professional to help you formulate a tax and income strategy that’s best for you.

3. You Get “Free” Money

Many employers include matching-contribution provisions in their 401(k) or SIMPLE IRA plans. If you are a participant in such a plan and you are not making salary-deferral contributions, you could be losing the benefits offered by your employer. At a minimum, you should consider contributing up to the maximum amount your employer will match. Not taking your employer’s offer to match contributions means you’ll miss out on free money.

Like your own contributions, the matching funds from your employer accrue earnings on a tax-deferred basis and are not taxed until you withdraw the amount from your retirement account. Below, we’ll look at another example examining John’s situation.

Example

John works for ABC Company, which agrees to make a matching contribution of 50 cents on every dollar, up to a sum equal to 6% of each employee’s compensation. John’s compensation is $31,000 per year, of which 6% is $1,860. If John contributes $2,000 from his paychecks throughout the year, John will receive an additional $1,000 contribution to his 401(k) account from ABC Company (50% of $2,000). If John wants to receive the maximum 6% of his compensation ($1,860) that ABC would contribute to his 401(k) account, John must contribute $3,720 per year.

If John had chosen not to make any salary-deferral contributions, he would lose not only the opportunity to reduce his taxable income and the benefit of tax-deferred growth but also the matching contribution from his employer.

Please bear in mind that a plan may require that an employee complete a certain number of years of service at the company before the employer contributes matching funds to the 401(K)—a process called vesting. Your funds become 100% vested once you complete the necessary years of service, which means you don’t own the contributed funds by the employer until you’re vested. However, any amounts that you contribute are immediately 100% vested.

Traditional IRAs Can Help

As you can see, there are many benefits to making salary-deferral contributions to your employer-sponsored plan. If your employer does not offer a plan with such a feature, consider funding an individual retirement plan (IRA) instead.

An IRA doesn’t come with an employer-matching benefit, but you receive a tax deduction in the years in which you contribute money. Also, any earnings grow tax-free, and you’re not taxed on the money until you withdraw it in retirement. However, the contribution limits are lower for IRAs versus 401(k)s. The annual contribution limit is $6,000 for 2020, 2021, and 2022 — while those who are aged 50 and over can contribute an extra $1,000 as a catch-up contribution.

Or, if you have the option and can afford it, contribute to both an IRA and your employer-sponsored plan. Contributing to your retirement plan helps ensure a financially secure retirement. As always, consult with your tax professional for assistance in making decisions on financial matters.

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The Impact of Ending the U.S. Embargo on Cuba

Randy

Many argue that ending the embargo on Cuba will not only make U.S. consumers happy, but also help its economy and bring greater freedom to Cuba.

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Want to Retire Early? Think Again

Randy

Is it bad to retire early? Here are eight good reasons to put off your retirement date.

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Benefits of a Solo 401(k) for the Self-Employed

Randy

If you are self-employed, you may be able to set up a tax-advantaged solo 401(k) retirement savings plan. Find out what the benefits are.

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Why You Should Consider an HSA Even With a Lower Salary

Randy

A health savings account (HSA) is a good deal for almost anyone who wants to save on taxes and healthcare costs. Here's how it works.

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Home Appraisals: Your Key to a Successful Refinance

Randy

When you refinance your mortgage, everything hinges on the appraisal. The key is understanding how appraisals work and how to prepare your home.

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A Guide to Trading Binary Options in the U.S.

Randy

Binary options are financial options that come with one of two payoff options if the contract is held until expiration: a fixed amount or nothing at all. That’s why they’re called binary options—because there is no other settlement possible. The premise behind a binary option is a simple yes or no proposition: Will an underlying asset be above a certain price at a certain time?

Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal among traders and newcomers to the financial markets. As simple as it may seem, traders should fully understand how binary options work, what markets and time frames they can trade with binary options, the advantages, and the disadvantages of these products, and which companies are legally authorized to provide binary options to U.S. residents.

Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative—but only if the trader fully understands the two potential outcomes of these exotic options. 

Key Takeaways

Binary options are based on a yes or no proposition and come with either a payout of a fixed amount or nothing at all, if held until expiration.These options come with the possibility of capped risk or capped potential and are traded on the Nadex.Bid and ask prices are set by traders themselves as they assess whether the probability set forth is true or not.Each Nadex contract traded costs $1 to enter and $1 to exit.

U.S. Binary Options Explained

Binary options provide a way to trade markets with capped risk and capped profit potential, based on a yes or no proposition.

Let’s take the following question as an example: Will the price of gold be above $1,830 at 1:30 p.m. today? 

If you believe it will be, you buy the binary option. If you think gold will be at or below $1,830 at 1:30 p.m., then you sell this binary option. The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.

The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then, you will pay $44.50, excluding fees. If you decide to sell right then, you’ll sell at $42.50, excluding fees.

Let’s assume you decide to buy at $44.50. If at 1:30 p.m. the price of gold is above $1,830, your option expires and it becomes worth $100. You make a profit of $100—$44.50 = $55.50 (minus fees). This is called being in the money. But if the price of gold is below $1,830 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested, plus the fees. This called out of the money.

The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss, compared to letting it expire out of the money.

A Zero-Sum Game

Eventually, every option settles at $100 or $0—$100 if the binary option proposition is true and $0 if it turns out to be false. Thus, each binary option has a total value potential of $100, and it is a zero-sum game—what you make, someone else loses, and what you lose, someone else makes.

Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, and so the trade costs you $44.50, excluding fees. The person who sold to you has a maximum risk of $55.50 if the option settles at $100—$100 – $44.50 = $55.50, excluding fees.

A trader may purchase multiple contracts if desired. Here’s another example:

S&P US 500 index > 4405.2 (4:15 p.m.). 

The current bid and offer are $18.00 and $24.00, respectively. If you think the index will be above 4405.2 at 4:15 p.m., you buy the binary option at $24, or place a bid at a lower price and hope someone sells to you at that price. If you think the index will be below 4405.2 at that time, you sell at $18, or place an offer above that price and hope someone buys it from you. 

You decide to buy at 24, believing the index is going to be above 4405.02 (called the strike price) by 4:15 p.m. And if you really like the trade, you can sell (or buy) multiple contracts.

Figure 1 shows a trade to buy one contract (size) at $24. The Nadex platform automatically calculates your maximum loss and gain, maximum ROI, and probability in-the-money (ITM) when you create an order, called a ticket.

Nadex Trade Ticket with Max Profit, Max Loss, and Probability ITM

Source: Nadex

The maximum profit on this ticket is $76 and the maximum loss is $24, excluding fees.

Determination of the Bid and Ask

The bid and ask are determined by traders themselves as they assess the probability of the proposition being true or not. In simple terms, if the bid and ask on a binary option is at 85 and 89, respectively, then traders on the buy-side are assuming a very high probability that the outcome of the binary option will be yes, and the option will expire worth $100 for buyers. If the bid and ask are near 50, traders are unsure if the binary will expire at $0 or $100—it’s relatively even odds.

If the bid and ask are at 10 and 15, respectively, that indicates traders on the sell-side think there is a high likelihood the option outcome will be no, and expire worth $100 for sellers. The buyers in this area are willing to take the small risk for a big gain. While those selling are willing to take a small—but very likely—profit for a large risk (relative to their gain). 

Where to Trade Binary Options

Binary options trade on the Nadex exchange, the first legal U.S. exchange focused on binary options. Nadex, or the North American Derivatives Exchange, provides its own browser-based binary options trading platform which traders can access via demo account or live account. The trading platform provides real-time charts along with direct market access to current binary option prices. 

Binary options trade on the Nadex—the North American Derivatives Exchange.

Binary options are also available through the Chicago Board Options Exchange (CBOE). Traders with an options-approved brokerage account can trade CBOE binary options through their traditional trading account. Not all brokers provide binary options trading, however. 

Fees for Binary Options

Each Nadex contract traded costs $1 to enter and $1 to exit.

If you hold your trade until settlement and finish in the money, the fee to exit is assessed to you at expiry. But if you hold the trade until settlement, but finish out of the money, no settlement fee is assessed.

CBOE binary options are traded through various option brokers. Each charges its own commission fee. 

Pick Your Binary Market

Multiple asset classes are tradable via binary option. Nadex offers trading in major indices such as the Dow 30 (Wall Street 30), the S&P 500 (US 500), Nasdaq 100 (US TECH 100), and Russell 2000 (US Smallcap 2000). Global indices for the United Kingdom (FTSE 100), Germany (Germany 40), China (China 50), and Japan (Japan 225) are also available. 

Trades can be placed on forex pairs: EUR/USD, GBP/USD, USD/JPY, EUR/JPY, AUD/USD, USD/CAD, GBP/JPY, USD/CHF, EUR/GBP, AUD/JPY, as well as US/MXN.

Nadex offers commodity binary options related to the price of crude oil, natural gas, gold, silver, copper, corn, and soybeans.

Trading news events are also possible with event binary options. Buy or sell options based on whether the Federal Reserve will increase or decrease rates, or whether jobless claims and nonfarm payrolls will come in above or below consensus estimates. 

The CBOE offers two binary options for trade. An S&P 500 Index option (BSZ) based on the S&P 500 Index, and a Volatility Index option (BVZ) based on the CBOE Volatility Index (VIX). 

Pick Your Option Time Frame

A trader may choose from Nadex binary options (in the above asset classes) that expire intraday, daily, or weekly.

Intraday options provide an opportunity for day traders, even in quiet market conditions, to attain an established return if they are correct in choosing the direction of the market over that time frame.

Daily options expire at the end of the trading day and are useful for day traders or those looking to hedge other stock, forex, or commodity holdings against that day’s movements.

Weekly options expire at the end of the trading week and are thus traded by swing traders throughout the week, and also by day traders as the options’ expiry approaches on Friday afternoon. 

Event-based contracts expire after the official news release associated with the event, and so all types of traders take positions well in advance of—and right up to the expiry. 

Trading Volatility

Any perceived volatility in the underlying market also tends to carry over to the way binary options are priced.

Consider the following example. Will the EUR/USD be above 1.1815 with 1½ hours left until expiration, while the spot EUR/USD currency pair trades at 1.1825? When there is a day with low volatility, the spot EUR/USD may have very little expectations of movement and the cost to buy or sell a contract may be in the $90 range. The EUR/USD is already 10 pips in the money, while the underlying market is expected to be flat. So the likelihood that the buyer receives a $100 payout is high.

But if the EUR/USD moves around a lot in a volatile trading session, the cost to buy or sell the contract will get pushed closer to $50 as the probability of the underlying market price staying over the 1.1815 strike is lower due to the potential for a larger market move.

Pros and Cons of Binary Options

Unlike the actual stock or forex markets where price gaps or slippage can occur, the risk of binary options is capped. It’s not possible to lose more than the cost of the trade, including fees. 

Better-than-average returns are also possible in very quiet markets. If a stock index or forex pair is barely moving, it’s hard to profit, but with a binary option, the payout is known. If you buy a binary option at $20, it will either settle at $100 or $0, making you $80 on your $20 investment or losing you $20. This is a 4:1 reward to risk ratio, an opportunity which is unlikely to be found in the actual market underlying the binary option. 

The flip side of this is that your gain is always capped. No matter how much the stock or forex pair moves in your favor, the most a binary option can be worth is $100. Purchasing multiple options contracts is one way to potentially profit more from an expected price move.

Since binary options are worth a maximum of $100, that makes them accessible to traders even with limited trading capital, as traditional stock day trading limits do not apply. Trading can begin with a $100 deposit at Nadex as long as you have sufficient funds in your account to cover your maximum risk for a trade. 

Binary options are a derivative based on an underlying asset, which you do not own. You’re thus not entitled to voting rights or dividends that you’d be eligible to receive if you owned an actual stock.

The Bottom Line

Binary options are based on a yes or no proposition. Your profit and loss potential are determined by your buy or sale price, and whether the option expires worth $100 or $0. Risk and reward are both capped, and you can exit options at any time before expiry to lock in a profit or reduce a loss.

Binary options within the U.S are traded via the Nadex and CBOE exchanges. Foreign companies soliciting U.S. residents to trade their form of binary options are usually operating illegally. Binary options trading has a low barrier to entry, but just because something is simple doesn’t mean it’ll be easy to make money with. There is always someone else on the other side of the trade who thinks they’re correct and you’re wrong.

Only trade with capital you can afford to lose, and trade a demo account to become completely comfortable with how binary options work before trading with real capital. 

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