Using Binaries for Short Term Directional Trading

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Isabella Malone
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1 Using Binaries for Short Term Directional Trading Binaries can be used to take an intra-day directional view on underlying markets, allowing the trader to go long or short in a market for a fraction of the margin necessary when trading more conventional contracts. And the usual benefits of Binaries apply a trader s risk is strictly capped without the danger of being stopped out by a temporary adverse move. This presentation shows you how to use Binaries, either singly or strategically combined, to tailor your exposure to an underlying market. Futures trading and options trading involve risk, which may result in financial loss, and are not suitable for everyone. Any trading decisions that you may make are solely your responsibility. The trading activity and other information presented herein are for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular financial instrument offered on Nadex.

2 As an example, let s look at Nadex s US 5 Binaries, which settle based on an expiration value calculated by reference to the CME E-mini S&P 5 Futures. In this hypothetical example, the CME E-mini S&P 5 Futures for March are trading at The recent price action of these futures, as seen in the graph below, leads you to believe that the market has just broken through some short term resistance at the 125. level. You believe that over the next couple of hours a market rally of a further 5-1 points is significantly more likely than a drop back below 125. Possible short term break out Current level Possible resistance level pm 1pm 2pm S&P 5 is a registered mark of the McGraw-Hill Companies, Inc. CME and E-mini are registered marks of the Chicago Mercantile Exchange Inc. Nadex is not affiliated with these organizations and neither they nor their affiliates sponsor or endorse Nadex or its products in any way.

3 Consider the ladder of end-of-day (expiration at 4:15pm ET) US 5 Binary contracts typically available on Nadex: Daily US 5 (Mar) > These prices can be viewed as consensus probabilities generated by Nadex market participants. So, for instance, the generality of Nadex traders perceive only a 15-18% chance of the US 5 settlement being higher than 1256 at the end of the day. And they believe that the probability of the market holding above 125 at the end of the day is between 66.9% and 7.4%.

4 If you believe in a 5 point rally by the end of the day, to approximately 1257, a strategy you could use is to buy the >1256 contract at 18. For each contract purchased you would be risking $18 to potentially make a profit of $82. If you perceive the potential for a rally of around 1 points you could buy the >1259 contract at 6. In this case, for each contract purchased, you would be risking $6 to potentially make $94. Or you might even buy the >1262, risking $2.8 to potentially make a profit of $97.2. Taking a less bullish view, if you believe the market will simply hold above the key 125 level, you could buy the >125 contract at 7.4, risking $7.4 to potentially make a profit of $29.6. Daily US 5 (Mar) > Back a strong (approx 1 pt) rally by buying one of these contracts very small risk, very large potential reward for an outcome the market believes is very unlikely Back a moderate (approx 5 pt) rally by buying this contract small risk, large potential reward for an outcome the market believes is pretty unlikely Back any kind of rally, and still profit even if there is a small fall, by buying this contract large risk, small potential reward for an outcome the market believes is somewhat likely The following slides show the kinds of P&L profile you can generate with these and other strategies. Examples do not include fees and commissions, which may vary by broker. Examples assume all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

5 Long 5 lots of 18 5 Potential profit (= $41) Potential loss on 5 lot position (= $9) Daily US 5 (Mar) > Buy 5 - Collateral required to enact this intraday binary strategy: $9 In this strategy, going long the >1256 contract, you would be backing the underlying market to be more than 4 points higher by the end of day. The consensus of other Nadex participants is that this is only 15-18% likely. Assuming you hold the position until expiration, each contract purchased would risk $18 to potentially make $82 (you buy at 18, and final settlement must be either or 1). In this example 5 lots are being traded, so your maximum possible loss (and total required collateral) is 5 x 18 = $9. Note that you do not have to hold the position until expiration you might choose to exit early if the market moves up a few points in the short term and you do not believe the rally will be sustained. The price at which you could exit under these circumstances will depend on the precise size of the rally and the amount of time still remaining until expiration, as these two factors will shape the new probability that the >1256 outcome will occur. Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

6 Long 5 lots of Potential profit (= $288.5) Potential loss (= $211.5) Daily US 5 (Mar) > Buy Collateral required to enact this intraday binary strategy: $211.5 This strategy, going long the >1253 contract, backs the underlying market to be more than just 1 point higher by the end of day. This is a less bullish view than the previous strategy and the consensus of Nadex participants is that the outcome is more probable, at a likelihood of %. Because success is more likely, your risk/reward ratio is less favorable than in the previous example. Assuming you hold the position until expiration, each contract purchased would risk $42.3 to potentially make a profit of $57.7 (you buy at 42.3, and final settlement must be either or 1). In this example 5 lots are being traded, so your maximum possible loss (and total required collateral) is 5 x 42.3 = $ Once again, though, you are not tied in to risking the whole $211.5 by waiting until expiration. If you feel the position is not working out (or if it is going right and you want to take an early profit) you can place an order to exit early. Provided your order is placed at a level which is attractive to other participants, you can close out your exposure to cap a loss or lock in a profit. Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

7 Long 5 lots of 6 5 Potential profit (= $47) Potential loss (= $3) Daily US 5 (Mar) > Buy 5 Collateral required to enact this intraday binary strategy: $3 This is an example of an extremely bullish strategy, backing the market to be more than 7 points higher at the end of the day by going long the >1259 contract. The consensus of Nadex participants is that the outcome is very improbable, at a likelihood of just 3-6%. Because success is considered so unlikely by other participants, your risk/reward ratio is far more favorable than in either of the previous examples. Assuming you hold the position until expiration, each contract purchased would risk $6 to potentially make a profit of $94 (you buy at 6, and final settlement must be either or 1). In this example 5 lots are being traded, so your maximum possible loss (and total required collateral) is 5 x 6 = $3. A full payout in this example is, by definition, extremely unlikely. But note that a short term rally of a few points may, depending on precise timing and magnitude, lift the consensus bid above 6 and allow an opportunity to take a profit on the strategy, even if the final goal of a 7 point rally is never achieved. Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

8 Long 5 lots of 7.4 Potential profit (= $148) Potential loss (= $352) Daily US 5 (Mar) > Buy 5-4 Collateral required to enact this intraday binary strategy: $352 At the opposite end of the scale you could back a strategy that pays off in the event of any kind of rally, regardless of size, and even still pays off in the event of a small fall in the market. The chart above shows the payoff profile for a long 5 lot >125 position. Given the market is currently above 125, it is more likely than not that this Binary will settle at 1; Nadex participants have, in this example, reached a consensus view that the exact probability stands at %. Because success is considered so likely by other participants, your potential risk in this case is larger than your potential reward. Assuming you hold the position until expiration, each contract purchased would risk $7.4 to potentially make a profit of $29.6 (you buy at 7.4, and final settlement must be either or 1). In this example 5 lots are being traded, so your maximum possible loss (and total required collateral) is 5 x 7.4 = $352. As ever, you are not tied in until expiration; an early exit from this position is possible, provided your exit order is at a level attractive to other market participants. Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

9 Long 2 lots of 42.3, long 3 lots of 18 4 Potential profit (either $61.4 or $361.4) Potential loss (= $138.6) Daily US 5 (Mar) > Buy 3 Buy 2 - Collateral required to enact this intraday binary strategy: $138.6 Here is a more elaborate strategy designed to spread the risk of taking a bullish Binary view. In this case the 5 lot position is split over two contracts, the >1253 and the >1256. If you do not exit early and instead hold the strategy to expiration you stand to make a profit of $61.4 (in the event of a settlement level above 1253 but no higher than 1256) or $361.4 (in the event of a settlement level above 1256). If the market finishes at or below 1253 you will lose $ Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

10 Long 1 lot of 42.3, long 1 lot of 18, long 3 lots of 6 Potential profit (either $21.7 or $121.7 or $421.7) Potential loss (= $78.3) Daily US 5 (Mar) > Buy 3 Buy 1 Buy 1 - Collateral required to enact this intraday binary strategy: $78.3 Here is an example of a 3 contract strategy designed to ratchet up a payout in the event of a large rally. In this case the 5 lot position is split over three contracts, the >1253, the >1256 and the >1259. Here your maximum risk, should you choose to hold the position until expiration, is capped at $78.3. A settlement level above 1253 will result in a profit of either $21.7, $121.7 or $421.7, depending on just how strong the market is by the end of the day. Example does not include fees and commissions, which may vary by broker. Example assumes all positions are entered into by trading at the available offer price rather than working orders at a more favorable level.

11 You can also use Binaries in conjunction with conventional futures contracts. The final few examples look at the effect of going long of a single lot of the CME E-mini S&P 5 Futures, while providing temporary protection against a sudden adverse move by shorting some US 5 Nadex Binaries. Possible short term break out Current level Possible resistance level pm 1pm 2pm Daily US 5 (Mar) > If you go long of the CME E-mini S&P 5 Futures, selling some of these Binaries can provide protection against an unexpected short term drop in the market

12 Short 5 lots of 66.9, long 1 lot CME E-mini S&P Daily US 5 (Mar) > Sell 5 (and buy 1 lot of futures) 4 Standalone Futures P&L Net Strategy P&L Standalone Binary P&L A short position in the >125, taken out at a price of 66.9, means that for each contract you stand to make $66.9 for a risk of $33.1. Going short of 5 lots, in conjunction with a long position of 1 lot in the futures, results in boosting your P&L by $334.5 in the event of a settlement at or below 125. This comes at the cost of reducing your P&L by $165.5 in the event of a settlement above 125. Strategy boosts futures P&L by $334.5 in this region Strategy reduces futures P&L by $165.5 in this region Example does not include fees and commissions, which may vary by broker. Example assumes all Binary positions are entered into by trading at the available bid price rather than working orders at a more favorable level. Payout profiles assume futures position is closed out at a level identical to the Nadex-calculated US 5 Expiration Value.

13 Short 5 lots of 87.3, long 1 lot CME E-mini S&P Daily US 5 (Mar) > Sell 5 (and buy 1 lot of futures) 6 4 Standalone Futures P&L Net Strategy P&L Standalone Binary P&L Strategy boosts futures P&L by $436.5 in this region Strategy reduces futures P&L by $63.5 in this region Cheaper (but less comprehensive) protection can be engineered by taking a short position in the >1247 at a price of 87.3, leaving you with a per-contract potential profit of $87.3 and a maximum possible per-contract loss of $12.7. Going short of 5 lots, in conjunction with a long position of 1 lot in the futures, results in boosting your P&L by $436.5 in the event of a settlement at or below This comes at the cost of reducing your P&L by $63.5 in the event of a settlement above Example does not include fees and commissions, which may vary by broker. Example assumes all Binary positions are entered into by trading at the available bid price rather than working orders at a more favorable level. Payout profiles assume futures position is closed out at a level identical to the Nadex-calculated US 5 Expiration Value.

14 Short 1 lot of 66.9, short 2 lots of 87.3, short 2 lots of 96.2, long 1 lot CME E-mini S&P Daily US 5 (Mar) > Sell 1 Sell 2 Sell 2 (and buy 1 lot of futures) 6 4 Standalone Futures P&L Net Strategy P&L Standalone Binary P&L Again, many more elaborate strategies are possible. In this one the 5 lot position has been split between 3 contracts, giving extensive downside protection to your long E-Mini position, at the cost of reducing P&L by $66.1 in the event that all the Binaries settle in the money. Strategy boosts futures P&L by either $33.9 or $233.9 or $433.9 in this region Strategy reduces futures P&L by $66.1 in this region Example does not include fees and commissions, which may vary by broker. Example assumes all Binary positions are entered into by trading at the available bid price rather than working orders at a more favorable level. Payout profiles assume futures position is closed out at a level identical to the Nadex-calculated US 5 Expiration Value.

15 Range of Markets We offer contracts on: Equity Indices: US 5, Wall Street 3, US Tech 1, US SmallCap, Germany 3, Korea, Japan 225, FTSE 1 Spot FX: Energies: Metals: Agriculturals: Economic Events: EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, GBPJPY, EURJPY Crude Oil, Natural Gas Gold, Silver, Copper Corn, Soybeans Initial Jobless Claims, Fed Funds, ECB Rate, Nonfarm Payrolls, Unemployment Rate Futures trading and options trading involve risk, which may result in financial loss, and are not suitable for everyone. Any trading decisions that you may make are solely your responsibility. The information presented herein is for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular financial instrument offered on Nadex.

Binary prices a proxy for probability

Binary prices a proxy for probability Binaries can be used to take a view on the short term volatility of key markets, giving a trader the potential to profit even without committing to a particular market direction. And, as usual with Binaries,