BINARY OPTIONS

·         Digital options

·         Fixed return options

·         All or nothing options

For few years binary options are traded at OTC (over the counter). In 2008 securities exchange commission (SEC) in US approved listing of binary options with continuous quotation and now binary options also available to individual investors

ü  Predictions of directions of price of underlying asset (stock, commodity, index, currency) with in expiry time

ü  No purchase or sale of underlying asset.

ü  Two possible outcomes

1.       Fixed gain – if expires – In the money

2.       Fixed loss – if expires – out of the money

Binary options trade

1.       Choose expiry time. (Minutes, day, week).

2.       Choose call or put

Ø  If u think price goes up Buy/Call.

Ø  If u think price goes down Sell/Put.

3.       Wait for expiry.

Ø  If the expiry is in the money – profit

Ø  If the expiry is out of the money – loss

Decisions

ü  Decision on underlying asset

·         Selection of assets for trading from different financial markets

·         What asset to trade has to do with the opening hours of various world stock exchanges

Basic four classes of assets

·         Commodity:  gold, silver, wheat, coffee, oil, platinum, etc...

·         Stocks:  city (US), apple (US), Google (US), etc...

·         Forex (currencies): 24hrs a day. GBP/USD,  USD/JPY

·         Indices (indexes): dow, s&p500, NasdaQ (us),  dax (germany).

Decision on amount to invest

Ø  The amounts you devote to trade should be dictated by risk management plan

Ø  Binary option brokers allow for low minimum investment

Deciding on the desired time frame

Ø  Binary options are short term investment instrument by definition

Ø  Time frame available is one minute to one week

Ø  Depending on trading plat form

Ø  Very small time frame one min and 5 mins

Ø  Possibly experiment a lot NOISE result of hedge funds activity

Ø  15 minute time frame is the best suggestion

Ø  This is the small enough to capture nice moves but big enough to eliminate the noise in the market and correctly the true trends

Ø  While preparing trading strategy it is best to experiment with various time frames

Ø  A trading strategy might work on larger time frame but not on small time frame “vice versa”

Deciding on types of trades

Major trading types

      Above/ below

      Buy / sell

      Call / put

Touch up and touch down

Ø  Touch the high strike price or low price

Ø  If it touches that within the expiration time the option expires in the money

 RANGE

 Range options will have a predetermined upper and lower boundary when buying a range option the buyer has to predict ‘in ‘or ‘out’

If more volatile -out

No or less volatile -in

ADDITIONAL FEATURES

Close now - allows you to close an option before time of expiry if the option not performing as planned

Extend – roll over allow you to exercise to extend the time of expiry in order to increase the odds of being IN THE MONEY

ADVANTAGES AND DISADVANTAGES OF BINARY OPTIONS

Advantages  

Risk control –

Ø  initial investment is fixed from the beginning thus amount of possible profit and loss is well known

Ø  You will never lose more than what you expected can determine your risk as completely as is possible there is a limit on how much earned or lost

Ø  Short time trading – daily hourly

Ø  We can decide the expiry time of the option will be it can be END OF THE WEEK or END OF THE MONTH

Ø  However most trades would prefer shorter time frames

Ø  Low minimum amounts binary brokers have low investment minimum thus allowing you to start with small amounts

Ø  Can start trading with 10 dollars

Online trading – all you need is a computer with internet access

Simplicity – very simple and straight forward all you need is to decide o which directions the asset moving

The main disadvantage is fee its morethan a spread the brokers fee is embedded in the bussines model if a binary options brokerage

BINARY OPTION TRADING RISK MANAGMENT

·         Not to risk too much money on any given trade

·         Many traders trade without thinking about risk they take only about the potential rewards

·         To succeed take in to consideration the maximum % of total trading money that you should risk in any one trade

·         Actually your ability to limit your losses is equally critical as your success in managing winning trades

3 tips to minimise risk and increase payouts

1.       Don’t trade with money that you cannot afford to loose

2.       Never borrow money while trading trade only with your own money

3.       Set and stick to a budget write it ... if you hit that no. quit trading for the day

4.       When you enter a trade , no matter how great it may be, always ensure to only invest conservatively

5.       It mean that you should not use more than 5% of your capital on any single trade

6.       There is always a risk factor involved conservative investment strategy helps you to conserve your money when things go wrong

7.       Never put all the eggs in the same basket

8.       A good money management strategy requires diversification ( currency and commodity)

9.       Losses needs to be stepping stone instead of having it affect you

10.   Certainly do not fall for the emotions and commit your entire amounts right away on one trade

11.   Investing small amounts continually helps you to take a self disciplined approach

12.   Use the advantage of minimum capital for trade

13.   Trade in small amounts until you have the sense of the assets that you are trading

14.   This can gradually increase your self confidence levels helps to automatically be aware of indicators and be able to prepare your investing strategy and ultimately help reduce the losses

15.   There will be a thin line between gambling and trading.

WHAT YOU NEED TO SUCCED IN BINARY OPTIONS

1.       Need to learn charts and how to read charts. charts are the main weapon in winning the binary options

2.       Any valid strategy involves reading and analysing charts they are  not hard to read and understand

3.       The most basic form of technical analysis would be look for SUPPORT and RESISTANCE levels charts in this way works best in moderately volatile market

4.       Another simple way of using charts is to look at moving averages such as the average price over 10 days

5.       It is better presentations of what the price is doing over a longer period of time

6.       Another simple pattern is RSI relative strength index

This highlights the situations where the market is

1.       Over bought

2.       Over sold

3.       Works potential reversal of trend

1.       RSI is the total points gained on up days divided by total points lost and gained multiplied by 100

2.       Pick a user friendly platform you will need a system that lets you back test strategies and program customised indicators and trading system without a lot of difficulty

3.       Pick a reputable company

4.       Select a provider which has superb customer service

SUPPORT

Support represents the level where buying pressure is powerful enough to absorb and overcome selling pressure

At support levels buyers move in to the market mopping up the imbalance between supplies (sellers)

And demand (buyers)

So that when it happens the price will stop fall and may probably rise.

Resistance opposite to support levels

Where volume of selling (supply)exceeds

Wher volume of buying (demand)

Simple moving average

It calculates the average price over a specific moving time period

Ex: 50 days SMA (simple moving average ) = avg mean price of last 50 days.

Hedging strategies using features and options

4.1 Basic Strategies Using Futures

While the use of short and long hedges can reduce (or eliminate in some cases

- as below) both downside and upside risk. The reduction of upside risk is

certaintly a limation of using futures to hedge.

4.1.1 Short Hedges

A short hedge is one where a short position is taken on a futures contract. It

is typically appropriate for a hedger to use when an asset is expected to be sold

in the future. Alternatively, it can be used by a speculator who anticipates that

the price of a contract will decrease.

1. For example, assume a cattle rancher plans to sell a pen of feeder cattle

in March based on the spot prices at that time. The rancher can hedge in

the following manner. Currently,

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• A March futures contract is purchases for a price of $150 • For simplicity, assume the rancher antipates (and does sell) selling 50,000 pounds (1 contract)

• Spot prices are currently $155 • What happens when the spot price is March decreases to $140? – Rancher loses $10 per 100 pounds on the sale from the decreased

price

– Rancher gains $10 by selling the futures contract for $150 and

immediately buying (to close out) for $140

– Effective price of the sale is $150

• What happens when the spot price is March increases to $160? – Rancher gains $10 per 100 pounds on the sale from the increased

price

– Rancher loses $10 by buying the futures contract for $150 and

immediately selling (to close out) for $160

– Effective price of the sale is $150

• The seller has effectively locked in on the price prior to the sale by offsetting gains/losses

2. Now assume the same for a speculator who takes a short position on a

March futures contract at $150

• If the price falls to $140, the speculator sells for $150 and immediately buys for $140, leading to a gain of $10 per 100 pounds [$5,000 gain

in value for one contract]

• If the price increases to $160, the speculator loses $5,000

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4.1.2 Long Hedges

A long hedge is one where a long position is taken on a futures contract. It is

typically appropriate for a hedger to use when an asset is expected to be bought

in the future. Alternatively, it can be used by a speculator who anticipates that

the price of a contract will increase.

1. For example, assume an oil producer plans on purchasing 2,000 barrels of

crude oil in August for a price equal to the spot price at the time. The

producer can hedge in the following manner by using crude oil futures

from the NYMEX. Currently,

• An August oil futures contract is purchases for a price of $59 per barrel

• Spot prices are currently $60 • What happens when the spot price in August decreases to $55? – Producer gains $4 per barrel on the purchase from the decreased

price

– Producer loses $4 by buying the futures contract for $59 and

immediately selling (to close out) for $55

– Effective price of the sale is $59

• What happens when the spot price in August increases to $65? – Producer loses $6 per barrel on the purchase from the increased

price

– Producer gains $6 by selling the futures contract for $59 and

immediately buying (to close out) for $65

– Effective price of the sale is $59

• The producer has effectively locked in on the price prior to the sale by offsetting gains/losses

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2. Now assume the same for a speculator who takes a long position on a

March futures contract at $59

• If the price increases to $65, the speculator sells for $59 and immediately buys for $65, leading to a gain of $6 per barrel [$12,000 gain

in value for five contracts]

• If the price increases to $55, the speculator loses $12,000

4.2 Basis Risk

In practice, hedges are often not as straightforward as has been assumed in this

course due to the following reasons

1. The asset to be hedged might not be exactly the same as the asset under

lying the futures contract

• actual commodity, weight, quality, or amount might differ

2. The hedger might not be exactly certain of the when the asset will be

bought or sold

3. Futures contract might need to be closed out before its delivery month

• many commodities do not have 12 deliery months

Basis is the difference between the cash price for the asset to be hedged and

the futures price. If the hedged asset is identical to the commodity underlying

the futures contract, the cash price and futures price should converge as delivery

nears. Changes in basis price do not impact the futures contract but do impact

the sales price for the producted to be hedged.

Below is a figure of the basis prices associated with Montana beef cows.

Notice the following:

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Ͳ$10

Ͳ$5

$0

$5

$10

$15

$20

$25

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Average Monthly Basis, By Cwt Steers, Billings 2000 to 2010

500Ͳ600 lbs 600Ͳ700 lbs 700Ͳ800 lbs

• Basis prices have strong seasonal patterns • Basis prices are not known and provide an additional layer of risk above and beyond price in the futures market

• Basis risk is often be hedged through the use of forward contracts • Basis volatility is relatively small compared to price volatility

4.3 Cross-Hedging

In the case when an asset is looking to be hedged and there is not an exact

replication in the futures/options market, cross hedging can be employed.

For example, if an airline is concerned with hedging against the price of jef

fuel, but jet fuel futures are not actively traded, they might consider the use of

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heating oil futures contracts.

• Hedge ratio - The ratio of the size of a position in a hedging instrument to the size of the position being hedged.

– When an asset to be hedged is exactly the same as the asset under

lying the futures contract, the hedge ratio is equal to 1.0

– The existence of basis risk often prevents this from happening

– It is not always optimal to cross hedge (not is it usually possible) to

hedge such that the hedge ratio equals 1.0

• Mimimum Variance Hedge ratio - The hedge ratio where the variance of the value of the hedged position is minimized

– For example, in the case of using heating oil futures (HOF) to hedge

jet fuel prices (JFP)

– The optimal hedge ratio (h∗) can be computed as

h∗ = ρ σJFP σHOF

(4.1)

where

ρ = corr(ΔHOF,ΔJFP) (4.2)

σJFP = stdev(ΔJFP) (4.3)

σHOF = stdev(ΔHOF) (4.4) ΔJFP = JFPt −JFPt−1 (4.5) ΔHOF = HOFt −HOFt−1 (4.6)

∗ What is the MVHR when ρ =0 .928, σJFP =0 .0263, σHOF = 0.0313? 0.778

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∗ This implies that the airline should hedge by taking a position in heating oil futures that corresponds to 77.8% of its exposure.

– The Optimal number of contracts (N∗)can be computed as

N∗ = h∗ QJFP QHOF

(4.7)

where QJFP=size of position being heged (Jet Fuel Prices) and QHOF=size

of futures contract (Heating oil futures).

∗ heating oil contracts on NYMEX include 42,000 gallons ∗ assume the airline has exposure on 2 Million gallons of jet fuel. ∗ What is N∗? 37.03

4.4 An Aside on Statistics

For these statistical measures, assume we have two variables where x1 = (5 ,7,5,4,9,6)

and x2 = 420,630,330,380,800,500)

• Mean

¯ x1 =

1 n x1i = 16(5 + 7 + 5 + 4 + 9 + 6) = 6 (4.8) In excel, use AVERAGE function

• Standard Deviation σx1 = x1i − ¯ x12 n−1

= 1+1+1+4+9+0 5

=1 .789 (4.9)

In excel, use STDEV function

• Correlation

ρ = (x1i − ¯ x1)(x2i − ¯ x2) (x1i − ¯ x1)2 (x2i − ¯ x2)2

=0 .962 (4.10)

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In excel, use CORREL function

• Linear Regression To determine the intercept (a) and slope (b) in y = a + bx, use INTER

CEPT and SLOPE functions in excel. Note: R2 from the regression is

equal to the correlation, ρ.

4.5 Trading Strategies Using Options

Basic trading strategies include the use of the following:

• Take a position in the option and the underlying stock • Spread: Take a position in 2 or more options of the same type (bull, bear, box, butterfly, calendar, and diagonal)

• Combination: Position in a mixture of calls and puts (straddle, strips, and straps)

4.5.1 Trading Strategies Involving Options

• A long position in a futures contract plus a short postiion in a call option (covered call) (a)

The long position “covers” the investor from the payoff on writing the short

call that becomes necessary if prices increase. Downside risk remains if

prices drop.

• A short position in a futures contract plus a long postiion in a call option (b)

• A long position in a futures contract plus a long position in a put option (protective put) (c)

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• A short position in a put option witha short position in a futures contract (d)

The profits payoffs from these strategies is shown below.

Fundamentals of Futures and Options Markets, 7th Ed, Ch 11, Copyright © John C. Hull 2010

Positions in an Option & the Underlying (Figure 11.1, page 250)

Profit

STK

Profit

ST

K

Profit

ST

K

Profit

STK

(a) (b)

(c) (d)

Notice the similarities with these plots and that of the simple put and call

strategies discussed in chapter 9. To illustrate, we define the put-call parity

according to the equation below:

p + S0 = c + K exp−rt +D (4.11)

where p is the price of a European put, S0 is the futures price, c is the price of

a European call, K is the strike price for the call and put, and r is the risk-free

interest rate, T is the time to maturity of both call and put, and D is the present

value of the divends anticipated during the life of the options.

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rl Price Range Total Payoff ST

4.5.2 Spreads

• Bull Spreads - Long and Short positions on a call option where strike price is higher on the short position (K2 >K 1).

– Investor collects when prices increase somewhere between K1 and K2

– This strartegy limits the investor’s upside and downside risk

– In return for giving up some upside risk, the investor sells a call

option

– Both options have the same expiration date

– The value of the option sold is always less than the value of

the option bought Note: Recall, a call price always decreases as

the strike price increases

– There are three types of bull spreads:

1. Both calls are initially out of the money (lowest cost, most ag

gressive)

2. Only One call is initially in the money

3. Both calls are intially in the money (highest cost, most conser

vative)

• Bear Spreads - An investor hoping that the price will decline may benefit from a bear spread. Basic strategy is to buy and put with strike price (K1)

and sell another put with strike price (K2), where K1 >K 2.

– In contrast, the strike price of the purchased put will cost more than

the option that is sold.

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 11, Copyright © John C. Hull 2010

Bull Spread Using Calls (Figure 11.2, page 251)

K1 K2

Profit

ST

– Limit upside protfit potential and downside risk

– Another type of bear spread involves buying a call with a high strike

price and selling a call with a lower strike price.

• Box Spreads - A combination of a bull call spread with strike pricesK1 and K2 and a bear put spread with the same two strike prices

– The total payoff is always K2−K1. The value of the spread is always the present value of that gap, (K2 −K1)e−rt – If there is a different value (not equal to the present value), then

there is an arbitrage opportunity

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4.5.3 Combinations

• Straddle - Involves buying a call and put with the same strike price and expiration date

– The bundle leads to a loss when the price is close to the strike price

– The bundle leads to a gain when the price moves sufficiently in either

direction

• Strips and Straps

– Both of these strategies reward prices that deviate far from the strike

price

– Strip - a long position in a call and two puts with teh same strike

price and expiration date

A strip is a bet on a big move where a decrease in price is more likely

– Strap - a long position in two calls and one put with teh same strike

price and expiration date

A strap is a bet on a big move where an increase in price is more

likely

• Strangles - A put and a call with the same expiration date and different strike prices, with put strike price K1 and a call strike price K2, where

K2 >K 1.

– Similar shape compared to straddle, however prices need to deviate

more in a strangle in order for gains to be found

– The farther apart the strike prices, the less the downside risk and the

farther the price has to move for a gain to be realized