Binary Options Hedge vs Trading Barrier Options

Are Barrier Options the Right Choice for You?

Before one considers trading barrier options one should also consider the similar alternative investment, the binary options hedge. Although the investments are very similar in terms of in the money yields offered, the risk characteristics are considerably different. Many times the determining factor in deciding which asset to trade comes down to a choice of convenience versus control.

"The development of binary options trading has been a huge blessing for the world of hedge trading for retail investors," said Steve Wise of binary-option-broker.com. "It affords the retail trader the opportunity to make simple hedges in the marketplace as a means to trade for profit or as insurance against loss. Previously this sort of risk management trading was the realm of institutions and wealth managers."

Convenience vs Control

Wise added that when it comes to picking barrier options or attempting to use the binary options hedge it really came down to a choice of convenience or control. "Does the retail trader want to buy a spread of values outright with barrier options or does the trader want to have more control over when - and whether - an individual binary options contract is left open or hedged. The effort required to do either trade and the range of potential outcomes is considerably different depending on which contract you decide to use."

When a trader picks up a binary options contract with the intent to potential hedge the initial contract with an equal and opposite trade, the resulting combination of assets provides a small range of strike prices with a high yield of sixty to eighty percent and a very wide range of values with a modest loss - "Typically ten percent plus or minus," according to Wise. In theory the draw of opening one contract and then hedging it revolves around having the opportunity to create a window of values with a high yield while all other possibilities preserve most of the capital invested.

Boutique Solution vs Off-the-Shelf

On the other hand in the case of barrier options the retail trader effectively walks up to the counter and picks up whatever spread of values is offered by the barrier options broker. Said Wise, "The range of in the money expiration prices is set by the broker at purchase and the day trader then hopes the contract expires with the spot price somewhere in that money range." Once the contract is purchased, the trader effectively walks away having already bought both the put and calls at the same time. One major difference with the binary options hedge is that the tail risk - the possibility that the contract expires outside the money - results in loss of most or all of the investment. "In theory the tail risk is the price the trader pays for the typically wider spreads and convenience of buying a range of values with no initial open ended exposure," said Wise.

Regardless of whether a trader has an interest in barrier options or binary options it behooves them to take a basic options trading course to learn the ropes according to Wise.

Trading Options Course | Put Options

In the next part of our trading options course we'll start talking about put options, the opposite of call options (which we discussed in an earlier post).

Put Options Represent the Right to SELL

First and foremost put options represent the right to SELL an asset. The asset can be any number of things ranging from stocks to currencies to indexes to interest rates.  How you as investor profit from trading put options depends entirely on how you choose to use them.

Principal Elements of Put Options

A put option is a contract with specifically defined terms. Almost invariably the contract will consist of a strike price (at which the asset will be sold), an expiration date (on or before which the contract must be executed), the number of shares per contract (nearly always 100), and of course the asset to be bought or sold.  The person who OWNS the option has the right to SELL the asset to the person who SOLD the option in the first place.  That probably sounds totally confusing, so let's talk about a real world example.

Buying a Put Option on Apple Stock

It just so happens Apple Inc. is in the news today given the health of Steve Jobs is failing.  If you know Apple's history and Steve Jobs... as goes Steve, so goes Apple... so one might surmise that today it might be a good day if you're already an owner of a put option on Apple stock.  So lets pretend we went to buy a put option on Apple stock last Friday (the last day markets were open).

At the close of trading on Friday a January 2011 put option with a strike price of $345.00 (near Apple's approximate closing price on Friday which was $348) would have cost $5.91 to buy in the market. Buying (going LONG the Put Option contract) would cost $591.00 ($5.91/share x 100 shares/contract).

Now consider that if we were to execute the contract Friday we wouldn't get any money!  Why would we want to sell shares at $345/share when we could go into the market and sell them for $348?  Doesn't make sense does it?  And yet according to the finance pages there are 14,000+ contracts open at this time.

Why People Buy Put Options - Trading Options Course Lesson in Market Timing

Over the holiday weekend Steve Jobs announced he is taking a leave of absence from the company.  Steve is and always has been the driving force behind the value creation of Apple Inc.  The last time he took a leave the stock immediately tanked, and here we are years later about to open the market again after a "Steve is leaving" announcement and the shares are down $15 to ~$323.00.  Approximately how much will the put options on Apple Inc. stock be worth on Tuesday when the market opens?

The answer is the value of the put options will be AT LEAST the amount of money you can make by simply executing the contract and selling the shares, ie the difference between the strike price ($345) and the current market price ($323).  The put option contracts should open this morning at least $12.00/share, making the Friday investment of $591 now worth at least $1200. Not a bad return (doubling your money) for one weekend's risk, eh? (editor's note: for the record the $345 January 2011 put option opened around $13.00)

Now does the decision to buy put options for with a price of $345 make sense? I hope trading put options makes a little more sense to you today.

Options Trading Tutorial | Call Options Explained

In the next post of the options trading tutorial series we'll talk about call options. A call option represents the right to buy a specific number of shares of a company or other asset at a specific price on (or before - in the case of Standard -or American- options) a specific date.

Call Options Explained

A call options trading tutorial has to talk about three critical pieces of information: the strike price, the expiration, and the call premium. Each of these bits of information play a critical role in determining the ultimate return on investment for the options trader.

Call Options: Explaining the Strike Price
The strike price of a call option is the price at which the option holder (long position, or buyer of the call option) has the option to pay for a set number of shares of stock (or some other asset) on or before a certain date. If the shares of stock (IBM for example) is trading ABOVE the strike price of the option, the option is considered "in the money." A call option buyer (or LONG) would be able to execute the option contract, forcing the counterparty to deliver the specified shares at the strike price. The option holder (now a share holder, given that the shares have been delivered) would have the freedom to re-sell the shares into the market at a higher price (see put and call option trading examples) and therefore cashing in the difference between the price paid (strike) and price sold for (market) as trading profits.

Call Options: The Expiration Date Explained
The expiration date on a call option (standard or American options) refers to the date on or before which an option must be exercised otherwise it expires (or can be subject to automatic options execution - not always a good thing for the trader short of cash). A call option which expires out of the money is worthless while an in the money option pays a profit (explained above - the difference between strike price and the market price of shares less the call premium times the number of shares in the contract). On *MOST* stock options contracts, the expiration is the third Friday of the month at the close of trading in New York (4pm EST). Sometimes there are options contracts which expire at the end of a quarter. It is extremely important to know when your options contracts expire, and to have your trades settled long before then unless you intend to exercise the contracts (a rarity these days because of the huge cash commitment involved... and the fees).

Explaining the Call Premium
The call premium on a call option contract is the fee the buyer of the contract pays to the seller of the contract (through a clearing house - to be explained elsewhere later). The call premium is essentially the market price of the contract - meaning the "fair" price the market has established for the contract based on a number of factors, including the probability of in the money expiration, the risk free rate, the volatility of the market, the number of days before expiration, and the current price of the underlying stock or asset.

In this options trading tutorial on call options we explained call options premiums, expiration dates, and strike prices. Options trading is risky and can result in significant losses of capital.

Options Trading Tutorial - Surveying the Underlying Economics

Welcome to my options trading tutorial on blogspot. I wanted to jot down some thoughts on how I identify and exploit trading opportunities in the derivatives market to make a few extra bucks every month. Options trading isn't for everyone, and the strategy / style of trading I discuss here honestly requires a lot of confidence and patience in the face of an adverse market.

Options Trading in an Adversarial Market

Right now is an extremely adversarial trading market. The fundamental economics of the global economy are screaming "SLOWDOWN/CONTRACTION IMMINENT" however the largest global governments are throwing the kitchen sick at the problem of global macro-economic depression in an effort to keep the economy going. Successful trading requires being able to gauge the direction of the market at a given point of time, entering the market quickly, setting modest profit targets, and exiting the market before it has a chance to react to your exit strategy.

Key Terms in an Options Trading Tutorial

I'm going to assume you know the basic options trading terms. In the previous paragraph I have described the basic macro-economic picture in simplified terms. Two opposing forces: declining asset values due to real estate and bond market bubbles against government central banks pumping those same asset values up as fast as they can to prevent global economic melt-down.

Cash Is King in an Uncertain Market

What is the best place to be in a market with two extremely large and diametrically opposing forces? Clearly the answer is to be in cash as much as possible and trade into and out of the market with as short duration of trades as possible. In the simplest terms, duration is the length time holding an investment position prior to returning to cash. In an extremely dangerous market like today, duration is measured in days (and preferably - in minutes). This is not the time to be caught "holding the bag" when the market falls out from underneath you.

Having said that, given that economic prosperity and growth is really in all of our best interests, it behooves us to hope that the economy grows and the stock market goes up. The problem is that our pragmatic side knows that double digit global unemployment, overwhelming debt, and an ever widening gap between rich and poor leads to only one conclusion: civil unrest and economic collapse.

The wisest minds in finance and economics know these fundamental facts, and certainly some of those minds work on the trading floors of the biggest banks in the world. They HAVE to know that trading the short side of the market (expecting the market to go down) is the most obvious and profitable trade. The problem lies in that should they make all the money possible betting against the market and the governments and economies of the world they will likely lose their independence and be nationalized, their assets seized, and cushy lifestyles traded in for lynchings and bondage (or worse!).

To Shear or Skin a Sheep, That Is the Question

Whether to shear or skin the sheep, that is the question powerhouse banking interests have to ask these days. Multiple times over the last 30 years trading firms have gained a cumulative trillions of dollars of wealth and kept it for themselves. These trillions have changed hands at the expense of the blind money in the market - away from small investors, to 401Ks, to pension and or mutual funds and into the hands of high net worth individuals, hedge funds, and multinational banks.

The game today has gotten so out of hand it seems to have come to the point of revolution. We've recently seen riots in Greece, which standing on it's own may not seem like a big deal, but we're less than a year from seeing the same level of unrest and or violence in Spain, Portugal, Ireland, and the UK. It is not entirely out of the realm of speculation that riots in California and other debt swollen states are possible.

Adversaries Become Strange Bedfellows When Disparity Reaches the Point of Violence

A wise banker sees this writing on the wall and ultimately can't help but be co-opted by the governments determined to prevent their own overthrow then. That's the underlying economic theory (call it speculation if you wish) behind this options trading tutorial / trading strategy. Banks and governments have to work hand in hand to make it LOOK as though "all is well" long enough to fool the people so subjugated into believing the illusion. The trick is to keep just enough people (the mid-middle class basically) feeling just content enough to prevent uprising.

We'll talk next post about the likely market movements associated with this scenario of overwhelmingly negative economic fundamentals combined with a coordinated central banking intervention strategy.