Binary Options Founded in 1807, John Wiley & Sons is the oldest independent publish- ing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and market- ing print and electronic products and services for our customers’ profes- sional and personal knowledge and understanding. The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future. For a list of available titles, visit our Web site at www.WileyFinance.com. Binary Options Strategies for Directional and Volatility Trading ALEX NEKRITIN John Wiley & Sons, Inc. Cover Design: John Wiley & Sons, Inc. Cover Image: (c) Andy Hair/iStockphoto Copyright © 2013 by Alex Nekritin. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. 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Options (Finance) 2. Futures. I. Title. HG6024.A3N448 2013 332.64'53—dc23 2012032301 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 This book is dedicated to my parents, Nina and Boris Nekritin. Thanks for all your unconditional love and support. Without you, none of this would have been possible. Contents Foreword xi Preface xiii Acknowledgments xvii PART I Introduction to Binary Options 1 CHAPTER 1 What Are Binary Options? 3 On What Asset Classes Are Binary Options Available? 3 Binary Options vs. CBOE (Vanilla) Put/Call Options 10 Advantages/Disadvantages of Binary Options 13 Reasons to Trade Binary Options 14 PART II Binary Options Theory 17 CHAPTER 2 What Does Binary Mean? 19 Components to a Binary Option 20 Long Trading 22 Short Trading 24 CHAPTER 3 Pricing 29 Strike Price 29 Time Value 30 Price as a Natural Market Consensus 32 Reading a Binary Option Chain 35 vii viii CONTENTS PART III Trading Binary Options 41 CHAPTER 4 Binary Options Contract Collateral 43 Margin and Debit Risk of Vanilla Options and Futures 43 Collateral Explained 44 Binary Options Expiration Values 44 Collateralizing a Long Trade 45 Collateralizing a Short Binary Options Trade 50 The Mechanics of a Binary Options Short Trade 50 CHAPTER 5 Settlement 59 Settlement on Binary Option Long Trades 59 Commissions and Fees 73 CHAPTER 6 Entering and Exiting Binary Option Trades 75 Reading Quotes 75 Reading an Order Ticket 76 Exiting Trades 78 Exiting Your Trade before Expiration 81 CHAPTER 7 Keys to Trading Binary Options and More Examples 95 Gold Binary Examples 96 Copper Binary Examples 99 PART IV Binary Options Trading Strategies 105 CHAPTER 8 Volatility Trading Explained 107 Taking a Volatility Long Position (Buying Volatility) 108 Regulating Success Probability and Payout with Strike Prices 111 Taking a Volatility Short Position (Selling Volatility) 113 Regulating Range and Payout with Strike Prices 116 Max Loss, Collateral, and Max Profit Summary Table 120 Contents ix CHAPTER 9 Binary Option Behavior as Expiration Approaches 123 Understanding Delta 123 Delta and Price 127 CHAPTER 10 Technical Trading Strategies with Binary Options 129 Support and Resistance 130 Breakout Trading 135 CHAPTER 11 Fundamental Trading Strategies with Binary Options 139 News Releases 139 Political Events 144 Speculating on Actual News Releases 147 Economic Data Releases that You Can Speculate On 149 PART V Creating Your Binary Options Strategy 153 CHAPTER 12 Systems with Binary Options 155 Finding Your Edge 155 Proper Trading System Development 156 Back-Testing Binary Options Strategies 158 Three Back-Testing Rules 162 CHAPTER 13 Negative Emotions 165 Greed and Fear 166 How to Handle Negative Emotions 166 Find the Right System for You 168 Practical Steps to Mitigate the Negative Emotions 175 CHAPTER 14 Risk Management 183 The Process 184 Determining Position Size 185 x CONTENTS Risk Management on Option Spreads 190 Relationship between Position Size and Trading Psychology 199 Handling Unexpected Market Volatility 199 Benefits of Binary Options on Trading Psychology 202 Discipline of Expiration 206 PART VI Managing Your Binary Options Account 209 CHAPTER 15 Proactive System Improvement 211 System Cutoffs 212 Drawdown 212 Consecutive Losing Trades 215 Reinvestment Rate 216 Diversification and Account Distribution 220 Intersystem Diversification 220 Account Breakdown 221 PART VII Profiting with Volatility 223 CHAPTER 16 The Volatility Short Trading Rules 225 Premium Collection 226 Rule 1: Cut Off Your Losing Trades 231 Rule 2: Collect Enough Premium 234 Rule 3: Sell Far Enough Away from Market Price 240 Rule 4: Use Underlying Instruments that Revert to the Mean 242 Rule 5: Sell Options with Proper Duration until Expiration 244 Rule 6: Perform Additional Analysis in Order to Get a Feel for Market Direction 246 Rule 7: Attempt to Make Your Market 255 Conclusion 256 Glossary 259 Index 263 Foreword B inary options are a relatively new and unique way to take part in the fi nancial markets. Over the past decade they have become popular instruments in Europe and Asia, and more recently, over the past few years, have not only gained acceptance, but have seen widespread growth in the United States, particularly within the retail trading community. One may ask, “Why, with all of the investment vehicles available, stocks, futures, forex, options, exchange‐traded funds, and so on, would I want to take a look at another contract type?” This is a legitimate question. One of the main reasons traders may look to a contract like a binary option is risk control. Any seasoned trader in any market knows that profi t- ability on any given trade is secondary, but risk management on every trade is mandatory and of the utmost concern. This is particularly true when par- ticipating in leveraged markets such as futures and currencies, where one mistake can not only result in large losses, but in some cases, losses that exceed the amount of capital in the trader’s account. This can create an ugly scenario for any trader—the dreaded margin call. If you’re not famil- iar with this concept, just think of the reaction of Randolph and Mortimer Duke at the end of the movie Trading Places and you may have a good idea of the devastating effect a margin call can have. I n the case of a binary option, whether I am buying or selling, my risk is always limited and 100 percent defi ned up front, before the order is sub- mitted. What this means is that a trader can very closely manage the risk on every trade. No matter what happens in the world while the trade is on—geopolitical tensions, central bank announcements, natural disasters, whatever the case—the investor cannot lose more than is put up for the trade. No worries of margin calls or being margined out, and more impor- tantly, no chance of your broker calling you up and telling you that you have to deposit more funds—funds that you may not have. Another reason to consider binary options is simply cost. Many of you reading this may have wanted to speculate in the fi nancial markets. You may have been standing at the gas pump and thought, “I knew oil was go- ing up.” Or perhaps you were reading the newspaper, saw something that caught your eye, and said, “I think stocks are going up tomorrow.” Unfortu- nately for many, the cost of placing a trade in the traditional markets may xi