Crude Oil futures have been on an impressive rally for more than a week now, as shown on the 30-minute candle chart below . After a $4.50 bounce, this market is almost irresistible to short; however, going against the trend can be costly, especially if you are trading the futures contract outright, which costs $10.00 per tick or $1,000 per $1.00 move in the future price.
However, binary options give traders with all account sizes the ability to be able to counter-trend trade a market in a more responsible manner, because all contracts come with limited risk. Therefore, you will save part of the psychological exposure of having to negotiate with stops on positions.
Another benefit of binary options is their flexibility, which provides the opportunity for traders to craft a variety of strategies based on their own views. Today we will look at an example of creating a custom option spread based on a specific hypothetical view.
Please note, this is not intended to be a recommendation of any market view or of any specific strategy, but rather an illustration for educational purposes.
This rally in crude oil is becoming tempting to fade, and given the move, it’s at least hard to imagine that it will go up much further soon. Selling the weekly $50.75 strike which expires at Friday’s 2:30 pm EST close will give you exposure if this market starts to slip, and a pullback to that level would certainly not be unrealistic given how far it has gone.
When selling an option you want price to settle below the strike, and the potential reward would be the sell price, or $72.25 in this case, while the risk would be the difference between that sale price and the $100 base value, or $27.75. This strike is about .75 below the current market for crude, so this option will pay better than 250% on what could be less than a dollar move in the underlying.
Let’s say you want to find a way to cover some of your risk. With the Crude Oil inventories number due to come out today, and crude so heavily bought, you may think the last thing the market will do is go back up, and that the most vulnerable position today would be for some longs to take profit. To cover your risk, you decide to sell today’s 2:30 p.m. EST expiration, using the $52.00 strike, which is about .50 above current price.
Because this option is already in-the-money, its odds are currently more favorable, so the price is cheaper, and it can be sold for $22.25 on a risk of $77.75. To keep the profit all crude oil has to do is settle below the strike price today.
The maximum risk is on both contracts combined which is $105.50, meanwhile the maximum potential profit is from both sides combined which is $95.50, so in total, this combined position offers a near even risk-to-reward ratio.
There are multiple scenarios that could play out with this trade. Maximum loss would be reached if crude settles above $52.00 today and above $50.75 on Friday.
Maximum reward would be realized if crude settles below $52.00 today and below $50.75 on Friday.
If crude settles above $52.00 today but below $50.75 on Friday the total loss would be limited to $5.50, because the lower strike’s winnings would mostly compensate for the daily option’s loss.
If the reverse takes place and crude settles below $52.00 today, but above $50.75 on Friday, then the loss would be also be just $5.50; and in this case, the hedge to pay for the cost of the more directional option would have worked as intended.
This is just one example of how multiple options can be used to fit a market view on just one underlying contract, but this market can be traded in multiple ways. If you were bullish, you could take the opposite sides of these trades. When buying a binary option instead of selling it, your risk would be the amount paid, while reward would be the difference between the purchase price and the $100 payout. To trade from a bullish angle, you could either buy the weekly $50.75 strike, risking $79.50 to earn $20.50 on a settlement above the strike; and / or you could buy the daily $52.00 strike, risking $29.75 to earn $70.25 on a settlement above that strike.