Profit in Flat Markets with Binary Options

Binary options are simple contracts that have only two possible outcomes. If you are right about whether the price will rise or fall, you receive a fixed, pre-determined payout; if not, you lose the amount you invested.

The attraction of binary options is the opportunity to make significant returns on small moves of the underlying while always knowing exactly how much you stand to lose.

In this post we look at binaries and compare them to a simple spot purchase as well as vanilla options, futures and contracts for difference (CFDs) to highlight their benefits.

Suppose spot gold is currently trading at US$1,235 an ounce and you think the price will go up slightly.

What are your alternative trading strategies?

Strategy 1: Spot purchase. You buy 100 ounces of gold for $1,235/oz. If the price of gold ends up at $1,240/oz, you pocket a $500 gain (100 oz × $5), or 0.40%. For each dollar rise in the gold price, you make $1/$1,235 or 0.08%. This is depicted in the following payoff diagram showing the percent gain per dollar change in the price of gold.

Strategy 2: Long futures or CFD. You buy a long futures or CFD contract at $1,235 (one 100 oz contract equates to $100 per full point). To open your position, you are required to post an initial margin of 3% or $3,705 (1 contract × 100 oz × $1,235/oz × 3%). If the price of gold rises to $1,240, you will have gained $500 (1 contract × 100 oz × $5/oz) or 13.50%. For each dollar rise in the gold price, you make $100/$3,705 or 2.70%. The payoff diagram looks the same as for a spot gold purchase, except the percentage gain is much higher due to the leverage.

Strategy 3: Call option. You buy a $1,235 strike price call option. You pay a premium of $3.40/oz. If gold reaches $1,240/oz, your call option will be worth $5.00/oz and you will have made a 47.0% gain on your investment. If you are wrong and gold finishes below $1,235/oz, your call option will be worthless and you will have lost 100% of your investment. Your risk potential is limited to the premium (price) you pay; you can’t lose any more than you initially invested. You break even at $1,238.40/oz.

Strategy 4: Binary call option. You buy a $1,000 binary call option struck at $1,235 with a fixed payout of 75%. If gold finishes above $1,235, you make a 75.0% gain on your investment. If gold stays below $1,235, you will have a loss of 100% of your investment. You have the same downside risk as with the call option, but with a much steeper profit profile.

To summarise, the spot purchase has the lowest potential return. The futures or CFD trade provides a higher return on investment due to the leverage. Compared to the purchase of the underlying gold futures and CFDs, gold options offer advantages such as additional leverage since the premium payable is typically lower than the margin requirement needed to open a position in the underlying gold futures or CFD as well as the ability to limit potential losses to only the premium paid to purchase the option. The binary option outperforms them all in our example. The call option will only beat the binary if the gold price goes over $1,241.

Leverage is a double edged sword. The above examples only depict positive scenarios whereby the market is favourable towards you. If the market turns against you, you will be required to top up your account to meet the margin requirements in order for your futures or CFD position to remain open and the call and binary option will have lost 100% of the investment value.

There is no such thing as a free lunch, but in flat markets, nothing beats binary options.