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Using Binary Options To Trade Mean Reversion in the Stock Market

Using Binary Options To Trade Mean Reversion in the Stock Market


This article was originally published here.

"To catch a falling knife" in trading refers to buying a price which has fallen rapidly. A trader who chooses to take this strategy is hypothesizing that the rapidity of the move implies it may only be temporary. Moreover, as anyone who was trading saw during the flash crash of 2010 or the Treasury flash crash of 2014, quick moves can become overextended, oftentimes reverse themselves completely. Those who choose to "catch a falling knife," or more generally "stand in front of a bus"* can reap immense profits. But there are no free lunches; those profits come at risk of losing an uncertain amount of money while you wait for mean reversion.

The risk of dip-buying is illustrated nicely by another old saying in trading: the market can stay wrong longer than you can remain solvent. What traders mean by this is that even if you are eventually proven correct and the market rallies, in the meantime the market could go down so much you experience a margin call, forcing the closure of your position. Even though the market eventually rallies, your position is essentially stopped out.

One way to expose yourself to the upside of dip-buying without the risk of a margin call is to structure your trade using binary options. If the S&P 500 is trading at 2075 at 9:30am and collapses to 2045 by 10:30am, you could simply buy the S&P 500 futures. In that case your risk could be greater than the margin you put up as collateral. If the market moves down enough to trigger a margin call your position will be closed at a loss even if the futures rally back to 2065.

This is not the case with a binary option. For example suppose in the above scenario you buy a 2060 binary when the market is at 2045 for about $15. Whether the market goes down to 2035 or 2025, the max you can lose is your $15 collateral plus commissions. If the market eventually rallies back to 2065 you will make $85. With binary options you keep the position on as long as you hold the option.

*(veteran traders will recognize these terms immediately, as these are technical terms, just kidding. But seriously these are metaphors for any trade which goes against the trend and are most certainly not literal terms!)

Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.

Posted-In: Education Options Markets General


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