Binaries Explained and How to Use Them

Binary options are quite simply a form of option that offers one of two outcomes and hence the name ‘binary’ which typically describes an outcome of either 0 or 1.

In spreadbetting, binaries are available on a wide variety of instruments for example the FTSE 100, S&P500, currencies, European indices, gold etc.  You can also bet on a binary outcome with as little as 10 mins to the expiry – this is more akin to true gambling, however, than typical spreadtrading. The price range of a binary in spreadbetting is zero – 100. Zero representing the 100% probability of the outcome NOT occurring, and 100 representing the 100% probability of the outcome occurring.

Let us look at how one works using the FTSE 100:

The FTSE 100 may be trading at say 5600 at the open of business on a particular day. If you were to play a daily binary bet on the probability of the FTSE closing UP on that day, it might be priced at say 50.  What this means is there is a 50% chance at the time of the bet purchase of the FTSE closing either up or down. Let’s say that as the day progresses the FTSE actually falls and the index is trading down 50 points at midday. The probability of the index closing up, particularly taking account of the time remaining that day (4 1/2 hrs), has therefore diminished materially now and so is likely to be somewhat less than 50% at that point. Thus, in this instance, the binary is likely to be priced at say 20, i.e. there is now only a 20% chance of the FTSE 100 closing up on the day.

There are 2 ways you can play a binary – you can either buy the binary, or you can either sell the binary. In the example above, you might think to yourself that the 20% probability of the FTSE closing up on the day is mispriced and that historically, when the FTSE is trading down over 50 points and with only around 4 1/2 hours to the close, that less than 10% of the time would the FTSE stage a rally of that magnitude and close up. Thus, you would sell the binary at 20. If, however, the FTSE did close up on the day, your loss would be 80 (100 – 20) x your stake.

Here’s a list of some of the types of binaries that you can play:

A Straight Closure/Expiry binary

This is the same as the example used above. There is a fixed expiry point and the binary is a bet on the probability of the underlying instrument closing up (or down if a bet on an instrument closing down) at that particular binary’s expiry point. This is the simplest type of binary to understand and is the most popular, and is generally available on a wide variety of instruments.

One Touch Binary

This is also a relatively straightforward type of binary that is, as the name says, a bet on the probability of the underlying instrument on which the binary is based touching a particular price point during the life of the binary bet, and which could be anything from 10 mins to 1 week. For example, you could enter a binary bet on the GBPUSD which is trading at say $1.5960 touching $1.60 during the next 30 mins. The price might be say 55 which means there is, at face value, a deemed 55% probability of GBPUSD touching the $1.60 level. With the ‘one touch bet’ you are basically stripping out the necessity of the binary actually expiring over (or under) the trigger level.

Two/Double Touch Binary

This type of binary involves the underlying instrument touching TWO price levels – one that is above the current price and one that is below the current price. For example, the S&P 500 might be trading at say 1350 and you enter a weekly binary on the S&P 500 that requires it to touch both 1330 & 1370 (the wider apart the two touch levels are and the shorter the timescale, the cheaper these binaries of course are).

These binary bets are suited to volatile markets where there is a higher probability of the particular instrument gyrating around the two trigger points – they are likely to be more successful in markets that are in the latter stages of a deep sell off where the downside is invariably lower than you always expect, but where sharp reversals can occur.  If the underlying instrument only touches one of the price points, the binary still expires at zero.

Either-or Touch Binary

This type of binary is very similar to the double touch binary except that it only requires the underlying instrument to touch ONE of the 2 trigger points. If it touches either of the trigger points, then it makes up at 100.

Ladder Binary

At its heart, a ladder bet is quite simply akin to an ‘accumulator’ bet that one would place on the horses. A trader on a ladder bet is looking for the underlying instrument to trade through a number of particular price levels at pre-determined time points. The price levels are arranged just like the rungs of a ladder, hence the name. For the trade to be successful, the asset has to have ‘climbed the steps’ at certain times in order for the trade to expire with a profit.

Let us look at an example to see how this would work and we’ll use the FTSE again. The index level may be say 5600. You could have a ladder with trigger points of 5630, 5650 & 5670 – expiry in this instance being 16:30 close of business. The ‘payout’ ratios ascribed to each of these trigger points may be for example 20% at 5630, 30% at 5650 and 50% at 5670. If the FTSE trades over 5630 at the expiry, you will receive a 20% payout and 30% at 5650 and 50% at 5670. It is basically a succession of one touch binaries.

How to use Binaries

Below is a list of how we, at Spreadbet Magazine, would suggest that you use binaries to the best effect:

Hedging Use

Say you are in a medium term trade where you are long the FTSE 100 at 5600 and you have profit on side with the index rising to 5700 (we’ll use a bet size of £10 per point for this illustration). On a particular day you might think that the FTSE is prone to a fall, but you do not want to exit your long bet which has, as we established, a medium term timescale to you.

What you could consider here is buying a binary for the FTSE to close down on that day. If, for example, it is 1pm and there’s just under 3 hours to go and the FTSE is up perhaps 20 points, then the binary might be priced around 25. You could thus buy a binary equivalent to say half your long spreadbet (£5) costing you therefore £125 (£5 x 25), and so if the FTSE did fall back and closed down on the day, then you would re-coup £500 (5 x 100 – the binary make up level). Your profit is therefore £375 (£500 – £125 cost). Remember though, your long bet of £10 per point would have lost £200+ (20 points + fall back x £10) and so you have mitigated your loss somewhat here.

Maximum Leverage

This type of trading is where you have a high conviction in a particular bet but you still do not want to expose yourself to a large potential equity drawdown should you be wrong.  For example, you might believe that the DAX is oversold at the 6500 level, but you are fearful of further volatility and the possibility of more sharp falls and so you are reluctant to open an outright long bet. You could, therefore, use binaries at this point to take a position on the Dax rising on successive days, safe in the knowledge that your downside is fixed at the cost of the binary (i.e. if your bet size is £20 & the binary costs 30 the cost to you is – 600).

Should the market continue to fall and your conviction grow further then, assuming you have not exhausted too much equity buying the market down via the binaries, you would progressively increase your binary bet size thus maximising your profit making potential when the upswing does come.

Catalyst trades

I particularly like these types of trade opportunities.  Basically you are looking to take a contrarian view on a particular news feature, for example the non-farm payrolls figure. If the market is expecting a low jobs creation number and there has been a degree of weakness in the market in the preceding days leading up to its release and with the market being down going into the release of the figures, then this is the type of set up I like on the bull side.

The Dow might be trading around 11900 (down say 40 points) and so you look at a ‘one touch bet’ at 12000 – in a lot of cases you get very sharp knee jerk reactions on important statistics and so, assuming the binary is priced appropriately (less than 30 is what I would look for here), this is the type of classic catalyst/contrarian trade you can play.

High Probability Swing Trades

This type of trade is where there has been a long run of successive rises or falls (history tells us 9 days down in a row and 8 days up without a reversal of either is a good point to look to take a countertrend trade) and the market is ripe for a corrective so called ‘swing’ trade.

I would typically play this by entering the countertrend outright long (or short) spreadbet in stages, and if the market continues to move away from me, then I would use the binaries as fixed cost ways to average in.

To conclude, binaries are really orientated to the more quick-fire short term type of trading or traders – it really is skirting the boundaries of typical spreadbet position taking and outright gambling. We would suggest that you allocate no more than 10% of your account value to this type of trading and that they be used in the scenarios highlighted above, particularly the deep oversold markets where the probability of a ‘swing’ trade back in your favour is high.

We would also caution against selling any binary below a price of 20 – no matter how likely the probability of the binary expiring at zero seems to you. The unexpected generally happens in the markets much more frequently than you would expect and if you’ve sold a binary at 20 you have basically laid odds of 5 to 1 against – do this frequently and have a run of bad luck and you’ll be staring down some pretty chunky losses quickly.

Similarly, I would also caution against buying a binary below 20 just because you think it is ‘cheap’. The old saying ‘you get what you pay for’ springs to mind – the chances of a binary that is priced below 20 ultimately making up at 100 is very slim. There is a time to buy these bets and that is as highlighted above with regards to high probability swing trades.

Finally, one thing I would say is that you can, of course, trade out of a binary at any time before the expiry – you do not need to run it right to the wire. If, for example, you bought a binary at 45 and let’s say it rises to 75, think about selling half or one third of your position – this way you are locking a good profit on a very high risk bet instrument. You will greatly extend the life of your binary account this way as it is plain and simple good risk management – the cornerstone of ALL successful traders.

Article reproduced from the May edition of Spreadbet eMagazine