Binary Options Trade – Combining a Put with a Long Stock Purchase
The utility of binary options is evident in the attached video in this post. What we try to show in the video is the combination of going long a stock and buying a small binary put option at the same time. We demonstrate the payoff chart in a way which should make evident why average traders ought to have this tool in their arsenal.
What Are the Principal Tactics of This Binary Options Demonstration
- The Trader Is Trying to Follow the Old Addage: “Buy on the dips” – but where is the bottom?
- The principal foundation of this trade is the acquisition of shares of a highly liquid common stock
- In this case we presume the trader is trying to time the market to find the market bottom
- In this case the trader pulls the trigger on a limit or market order for a desired security
- The trader then purchases a small a binary options put contract on the same security at the same price
Why Doesn’t the Trader Simply Buy at the Bottom?
Well that’s the million dollar question, isn’t it? The problem is that in a real time market environment nobody really knows where the lowest price on a given day or stretch of days will be. At some point a trader that is determined to acquire a position in a given stock has to pull the trigger on a trade, or have the trigger pulled for him in the form of a limit order. Unfortunately for retail traders like you and I – we are forced to buy stocks at the ask price – which is always some degree higher than the bid price. The difference between the prices is called the spread – or bid-ask spread. What this inevitably means is that we end up buying shares at a price higher than the absolute bottom price.
How to Reclaim Some of the Money Left on the Table During a Stock Purchase
If you are watching a stock price fall and decide to jump in at some point along the way – not wanting to miss and opportunity to get a desired stock at a good price – there is always the chance the stock will fall further than your entry point price. How can you insure yourself against such a fall? If the stock is one of the highly liquid stocks like Google or Microsoft, or possibly one of the popular forex cross rates or market indices you may be able to recoup some of the money left on the table by purchasing a binary options contract at the same time you jump in the market.
Download the companion binary options worksheet for this video
What Are the Payoffs on a Binary Put Option?
A binary put option works similar to a normal put option to the extent that if the share price drops below the strike price, the binary put option is in the money. Where the binary put option differs from the regular put option is that the binary put option pays a fixed yield of 60-81% depending on the contract purchased. The contract can also be structured to pay out at the end of the day or at the top of the hour, again depending on the availability of contracts and the preference of the trader.
What Purchase Levels Should a Trader Look at in Selecting Contracts?
This is going to vary by the trader, but as you’ll note in the video we show how a person can invest one dollar in a binary option contract for every sixty dollars worth of stock purchased in order to create a payoff structure that protects against a “purchase date” trading price drop of 1.6% (protection level varies with yield on the binary options) – which is certainly within the typical expected variability of most stock price levels.
With a little creativity and ingenuity the average trader ought to be able to get both the shares desired in the long stock market while also protecting himself or herself from “buyer’s remorse” – i.e. buying at a price above where the stock eventually settles on the trading date of purchase.
You can play around with our simple binary options trading worksheet to mock up your own options trading strategies using this “long binary options put long stock purchase” combination. This worksheet can be used to mock up hedging scenarios using any type of security, including foreign currency hedging – with a little adaptation. The point is that binary options can be an effective hedge for a number of securities and payment flows – providing you can find a contract that offsets your obligation (or receipt) and has the same or similar duration (daily, weekly, or monthly potentially depending on the broker and the security).
