Three Traders- Three Strategies for the Crude Oil Close
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Today, we will look at examples from yesterday that three different traders had about the Crude Oil close, using binary options for implementing their market views. The options discussed will be based on the daily 2:30 EST settlement, and are based on a $100 settlement value per contract.
Trader A: (small risk/ lower probability) believes that the Crude is likely to rally into the close. This trader is very aggressive with short-term, speculative ideas, and likes to risk little for a high return, knowing that his probabilities of success are small. He decides to buy the $45.00 strike option for a price of
$7.25, meaning that his maximum return will occur if the underlying futures rally and Crude closes above the $45 strike.
His risk is limited to the $7.25 cost for the option; and since each option contract has a $100 settlement value, the potential reward would be the difference between that base value and the purchase price of the option ($100 - $7.25), which would amount to a profit of $92.75. Although the trade has a low probability, this trade has a very high reward potential if the trade finishes in the money at expiration.
Trader B (modest profit goal) is also bullish into the close; however, she believes that Crude will maintain close to its current price and will not rally sharply. She decides instead to use a higher probability strategy that gives her a lower reward on more dollars at risk.
To accomplish this, she buys a $44.00 strike option at a purchase price of $95.75 per contract. This amount $95.75 per contract is the initial cost of how much she is risking on the trade.
Her potential profit would be the difference between that risk and the $100 settlement value ($100 - $95.75), which would be a profit of $4.75 or around a 5% return. All she needs for the trade to be profitable at expiration is for the Crude to close anywhere above the $44.00 strike.
Trader C (hedge/ protection) has other open trade positions on in Crude and wants protection if there is a close over $44.50 today. To create this hedge, he purchases the $44.50 strike at a price of $49.75 per contract, meaning that he is risking $49.75 to make $50.25 on every contract if the expiration value is above the $44.50 strike on the close. This trade has a potential yield of nearly a 1:1 reward vs. risk.
Each trade scenario had a bullish bias using binary options. However at expiration, only Trader B and C had binary positions that finished in the money as the Crude price was above $44.50 level but below $45.00 level at the 2:30 p.m. EST expiration.
Trader A’s position was nearly successful as the Crude price did end up trading above $45.00. Unfortunately the binary contract had already expired when the price level had been reached which meant that the trade was not profitable at expiration.
However Trader A (small risk/ lower probability) knew another way to profit using binary options. Prior to expiration, as the underlying market traded higher, his binary position increased in value, giving him the chance to exit the trade early. Locking in a profit early and not waiting until expiration is not a bad thing when his trade position had a low probability to be successful.
These are just a few the binary strike choses to show why it is important to consider time as well as direction and strike when implementing a market view using binary options.
Note: Exchange fees not included in calculations.
Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.
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