An investor believes that this market will be range bound during a set period of time. The index will bounce between a high and low level. One way to trade that opinion is to execute, for example, a Binary Call Option spread; that is, simultaneously buy a Binary Call Option and sell a second Binary Call with a higher strike price.
Let us assume that the investor wants to trade the DAX 30 Index on January 1, 2013 with a value of 7,350; the investor buys 7,325 strike price DAX 30 Binary Call Option expiring on February 15, 2013 and sells a February 7,425 Binary Call. The price of the call is 100 Euros and the payout is 85% or 85 Euros, and your losses are limited to 85% of your initial investment.
At expiration, DAX 30 Binary Options have only two possible payoffs: 1) 85 Euro if the Opening Settlement Value for the DAX 30 is equal to or greater than the Binary Option strike price; or 2) 0 Euro if the DAX 30 is less than the strike price.
For the long Binary Call Option, the investor would receive 85 Euros per contract if the DAX 30’s value was 7,325 or higher at expiration. For the short Binary Call Option, the investor would have to pay the 85 Euro per contract if the index value is 7,425 or higher at expiration.
There are three possible outcomes and let us examine each of them: 1) DAX 30 is below 7,325; 2) DAX 30 is at or above 7,325, but below 7,425; and 3) DAX 30 is at or above 7,425.
First, let us analyze the two outcomes at which the DAX 30 settles outside of the investor’s anticipated trading range. If the DAX 30 is less than 7,325 on February 15, then both spread sides or “legs” settle out-of-the-money and have a value of 0 Euro at expiration. The investor takes a 85 Euro loss on the long Binary Call position, which is offset by a gain of 85 Euro on the short Binary position so the net loss on the spread position is 0 Euro.
If DAX 30 is at or above 7,425 at expiration, then both “legs” settle in-the-money and have a value of 185 Euro per contract. The long position would have a gain of 85 Euro, but the loss on the short position would be 85 Euro, a net loss of 0 Euro.
Scenario |
Long Value |
Short Value |
Spread Value |
Long P&L |
Short P&L |
Spread P&L |
DAX 30 below 7,325 | 0 | 0 | 0 | (85) | 85 | 0 |
DAX 30 at or above 7,325, but below 7,425 | 185 | 185 | 370 | 85 | 85 | 170 |
DAX 30 at or above 7,425 | 185 | 15 | 200 | 85 | (85) | 0 |
However, if DAX 30 is between 7,325 and 7,425, the Binary Calls would have values of 185 Euros. The investor would realize a 85 Euros gain from the long Binary Option position, plus an 85 Euro gain from the short Binary Option position. The net P&L would be 170 Euros.
Remember that the investor should expect that the cost of a Binary Call spread covering a wider range of index prices will generally be higher than a narrow ranged Binary Call spread. Logically, this makes sense because the wider the index range the higher the probability of settling within a specified range.