The practice of selling index binary option puts is a strategy in which the trader gets credit at the open of the trade. The trader receives the premium and hopes that this strategy will work if the index rises in value from the strike price written. After all why sell at an index value of 13500 when the index is at 14000. The reason the trader is getting premium is that someone else has the right to sell and will assign that right to the binary option writer if the index value falls below the strike price. Thus this is the reason why the trader is going “naked’ as they are giving someone else an assignment right without any hedge if the market does indeed drop. The trader exposed themselves to an assignment. Selling index binary option puts is a strategy which from open generates cash for the trader. The amount of cash credited is a known amount which is the option premium.
On the other hand, if the index drops then losses can be large and conceivable unlimited because the amount that an index drops is likewise unlimited.
In summary here are the main points of naked put options
Maximum profit attained = premium received – commission paid
Maximum loss occurred = unlimited as no one knows how low is low in the markets. Despite these apparent risks, here are the advantages of selling binary index put options:
a) The trader can enter the market without paying any cash.
b) The trader can gain experience of the binary option market implementing this basic option trading strategy.
c) While covered calls also utilize selling binary options, there is a capital outlay because the position is hedged or “covered” with owning the underlying asset. In the case of an index, the trader could “own” the index by buying exchange traded funds or ETFs. Thus covered calls is more capital intensive.
d) The trade can be extremely profitable if successful.
e) The trader issues in effect an “IOU” hoping that it will expire valueless.
The risks associated with this trade are summarized accordingly:
a) The maximum profit earned is limited by the premium collected from the market
b) If the index level falls drastically, there will be huge losses
c) Applying this trade is not “free money” which some traders believe.
d) Traders who excessively sell puts without applying basic risk management place their portfolios of trading capital at risk of total loss.
Selling binary option puts can be a profitable strategy. As with any trading strategy, the profits will come if the market goes in the direction that the writer anticipates. Before writing the option, the trader needs to know the trend and needs to calculate if the premium to be collected is worth the risk incurred.