Basic instruments for analysis in options trading

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Trading Guide: The Importance of Basic Math in Trading Binary Options

Trading in binary options isn’t only about the markets. Mathematics has a huge role to play and it governs the

Trading is about making money. Making money on the binary options market is about carefully analyzing statistics and ultimately about basic math. Binary option brokers, for the most part, profit from what their clients lose. They are targeting an equilibrium in the market when for every buyer there is a seller and vice versa (i.e. there should always be an even amount of puts and calls), but that is rarely the case.

Traders also need math to be on their side. And since the rules of trading binary options are already set, traders just need to make the calculations. Unlike forex or stock trading, the risk/reward ratio is non-negotiable in binary options trading. The only thing left to improve or control in a sense, is the win rate.

Let’s say we have a digital option with an 80% payout, this means that if a trader wants to break even he has to win 5 trades for every 4 losses. In other words, a trader needs to win more often than he loses just to break even.

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To be able to make any money with an 80% payout, the trader needs to be right at least 60% of the time. It’s tough for traders to be able to correctly analyze the market and predict its direction. They also need to pick the option type that will best suit their trading style and market conditions.

The market will either be trending, in a range or a mixture of the two. Traders need to pick their time to strike and need to trade with a clear idea of what they are looking for. Keep in mind that emotions and mathematics mix just as well as oil and water. Traders need mathematics on their side.

Improving the chances of every single trade being a winner is what actually puts basic math on the trader’s side.

Chart analysis for binary options trading

The nuts and bolts of binary options trading are relatively straightforward. To make a long-term profit and avoid heavy losses however, you need to develop a solid trading plan and get your analysis right.

In this lesson we will focus on how technical analysis and the use of price charts can help you determine which asset to trade, which direction prices will move, what time frame will work best for you and at which levels you should enter trades. We will also introduce some of the main technical indicators that binary options traders find useful.

The importance of charts in binary options trading

Technical analysis involves the study of charts to identify historic patterns in a price that tend to repeat themselves under similar conditions. It is considered the most reliable form of analysis for binary options traders and will help you form a view on how prices are likely to behave in the short and long term.

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Technical analysis: the basics

Most technical analysis relies on the historical observation that asset prices have a tendency to hit areas of support or resistance through which they struggle to fall or rise, respectively. If these barriers are broken, price movements in the direction of the breach often gain momentum.

There are two main approaches to technical analysis that can help you identify support and resistance levels and predict how prices will respond to them: patterns and technical indicators. Some binary options traders favour one over the other. Many use a combination of both.

Traders who focus on technical indicators rely on indicators such as MACD, ADX and stochastics to alert them to trading opportunities.

Traders who focus on patterns try to identify specific shapes such as so-called ‘double top’ and ‘head and shoulders’ patterns as they form on their price charts.

One of the key challenges with this analysis style is that real-life chart patterns are rarely as picture perfect as the textbook examples. Traders therefore have to make a decision on whether what they see on their chart is a bonafide trading signal or not. As prices are constantly in motion, they also have to learn to anticipate a pattern forming before it completes, and to act on it fast.

Whichever approach you decide works for you, be careful not to over-complicate your analysis by focusing on too many indicators or patterns at once. A cluttered chart is hard to read and less reliable.

How to choose an asset to trade

Choosing the right asset or assets to trade with binary options can be key to your success.

It is possible to trade binaries on a wide range of underlying assets, from stocks and indices to commodities and foreign exchange, so make sure you choose a broker that offers you plenty of flexibility.

Different assets behave differently, and some work better with certain indicators, price patterns or time frames than others. Foreign exchange markets, for example, tend to move fast. A binary options trader focusing on the USD-GBP currency pair will therefore probably want to use charts with shorter time frames than might a trader of an industry index.

Be careful that you don’t try and trade too many assets at once – it’s far better to familiarise yourself with one or two and master your approach to them.

How to identify a trend or trend reversal

Because binary options trading at its heart involves betting on whether an asset price will rise or fall, identifying price trends and recognising when they may be about to run out of steam or change direction is one of the most important skills you must develop.

For traders that rely on technical indicators, one signal that an upward trend could be about to switch direction and reverse to the downside is when moving averages display a downward cross. When moving averages show an upward cross, this can signal that a downward trend will change to an upward move.

Another way that binary options traders can form a view on whether an existing trend is going to continue or reverse is by looking out for the so-called 1-2-3 setup.

This setup forms when the price of an asset continues moving higher or lower in the direction of an existing trend but then stops and pulls back slightly before continuing the trend.

One way of identifying the 1-2-3 setup is by monitoring Fibonacci levels to see if the price pullback is greater than 38.2% of the previous move. If it isn’t, most binary options traders conclude that the trend will soon continue and use the pullback as an attractive entry point for a new binary trade in the direction of the original trend.

If the 1-2-3 pattern fails to complete and price pullbacks are greater than 38.2% of the previous move, binary options traders often conclude that the trend is reversing. A double-bottom shape resembling the letter ‘W’ will sometimes form on the chart before the reversal gets underway.

Some binary options traders meanwhile use a combination of the Fibonacci retracement tool provided by most charting software and the stochastic oscillator.

The Fibonacci retracement tool helps traders identify when a price correction or retracement in the midst of a wider trend is about to end and the initial trend continue. As with the 1-2-3 setup, it allows traders to buy binary options traders at around the point the trend restarts.

To ensure a high probability trade, many will also wait for the stochastic oscillator – a technical indicator that identifies when a price has become ‘overbought’ (over 70 on the indicator index) or ‘oversold’ (below 30 on the indicator index) – to tell them a reversal is likely.

How to choose a time frame and expiry time

Price charts are broken into small bites known as time frames. These typically last for 1, 5, 15, 30, 45, 60 or 90 minutes, or for a whole day, week or month.

Most binary options traders start off using daily or weekly charts, and then graduate towards shorter time frames as they gain experience and if this suits their trading style and favoured underlying assets. Even for very short-term traders, however, it is sensible to check longer-dated charts at least daily, if only to keep abreast of slow-moving trends and form a view on how they might affect short-term price action.

Because binary options expire worthless if a certain scenario is not achieved within a specified time frame, they are extremely time sensitive. This means it is crucial to pick the right time frame and expiry so that trends have enough room to run.

If, for example, you correctly identify a downward trend and buy a put option, you could find your option expires out of the money if a retracement or correction to that trend occurs just before the contract runs out. In this scenario, you should have chosen an option with a longer time frame to allow the retracement to end and the trend to resume.

One way traders can allow themselves more room in such a scenario is by purchasing a roll over from their broker, if they offer this tool. A roll over allows you to extend the expiry time of your option if a price correction occurs and you think it will be short-lived.

One popular rule of thumb among binary options traders choosing expiry times is to go for one that is at least three times as long as the time frame of the strategy you have chosen. If, for example, the strategy you are following uses a five-minute chart, choose an expiry time of at least 15 minutes.

Also, try and gauge market volatility and momentum. If prices start to move very quickly after you received your trading signal, go for a shorter expiry time. If moves take a while to get going, opt for a longer expiry time.

Similarly, if market conditions are very volatile or choppy, use a shorter expiry time than you would in slow, ranging markets or periods of fairly smooth price action.

Summary

So far you have learned that:

  • by analysing historic price movements on the charts you can draw conclusions about its future direction
  • binary options traders use support & resistance, price patterns and indicators to predict price movements
  • a good way to choose an asset is by checking how fast or slow it tends to move
  • Binary option traders typically use moving average crossovers, the so called ‘1-2-3 pattern’ or Fibonacci retracements to determine market direction
  • combining two or more tools such as Fibonacci retracements and stochastics can give you powerful trading signals
  • binary option traders generally go for an expiry time that is at least 3 times longer than the time frame they take their signals from

Basic Options | Options Trading Strategies

Key Points

We review basic options trading strategies and how they can be used.

Discover how long calls and long puts can be profitable and why short calls and short puts carry greater risks.

Find out how you might select the strike price for your option depending on your level of bullishness or bearishness.

If you’re familiar with options basics such as open interest, pricing, sentiment and expiration cycles, then it’s time to put your knowledge to work. In this article, we examine how to do that, presenting some basic options trading strategies and discussing how they can be used in bullish and bearish scenarios.

Figure 1. Bullish vs. Bearish Options Trading Strategies

Source: Schwab Center for Financial Research

Long calls

A long call trade is often the first option strategy investors try. It can be difficult to profit from long call trades, but understanding this strategy can be the first step toward more complex options trades. A long call option is a bullish strategy , insofar as you believe the share’s price will rise enough in the future to be worth buying a call with a specified strike price, but unlike with a long stock trade (purchasing the stock outright), you generally have to be right about more than just the direction of the stock to be profitable.

The price of an option is based on many components, including: (1) type of option (call or put), (2) the strike price of the option, (3) the amount of time until the option expires and (4) the anticipated level of volatility in the underlying stock, index or ETF. To profit on a long call trade, you will usually need to be right about the direction of the underlying stock’s price movement, the size of the move and the timing of the move.

Here are a few other things about call options to keep in mind:

  1. Call options tend to move up or down along with the underlying instrument, though the moves are usually of a smaller magnitude.
  2. The lower the strike price, the higher the value.
  3. Option values are based in part on the number of days until expiration and generally lose a small amount of value with each day that passes. As a result, the closer the option gets to expiry, the lower its value tends to be.
  4. Option values are also based in part on the anticipated level of volatility in the underlying instrument, so if volatility expectations rise or fall, options values adjust accordingly. In general, the lower the anticipated volatility, the lower the value of the option.

Before you decide to enter into any option strategy, it is important to do some simple calculations to find the maximum gain, the maximum loss and the breakeven point—the price the underlying stock or index must exceed at expiration to be profitable.

Here is the formula you would use on a long call trade, assuming the position is held until expiration:

  • Long 1 XYZ Jan 50 Call @ $3
  • Maximum gain = unlimited
  • Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)
  • Breakeven point = 53 (50 strike price + 3.00 option premium)

Figure 2. Long Call Profit or Loss Visualization

Source: Schwab Center for Financial Research

As you can see in Figure 2, while the maximum potential loss on a long call trade is the price paid for the option, the potential profit is theoretically unlimited. Keep in mind that because the option has a limited lifespan, the move in the underlying stock needs to occur before expiration and be big enough to cover the cost of the option. It must also be sufficient to offset the erosion in time value and possibly changes in volatility. These factors work against the holder of a long option, resulting in a more difficult profit-or-loss scenario than one might think.

Short calls

S hort calls , also known as uncovered or naked calls, are bearish trades, and I generally don’t recommend using them. They would be particularly inappropriate for inexperienced options traders or traders without substantial risk capital. Still, I think it’s helpful to illustrate how selling a short call creates a profit-or-loss scenario that is exactly the opposite of a long call. Here’s an example:

  • Short 1 XYZ Jan 50 Call @ $3
  • Maximum gain = $300 (3.00 option premium received x 100 shares per contract)
  • Maximum loss = unlimited
  • Breakeven point = 53 (50 strike price + 3.00 option premium)

Figure 3. Short (Uncovered) Call Profit or Loss Visualization

Source: Schwab Center for Financial Research

An uncovered or naked call is an extremely risky position to trade. While the profit (if the stock drops in price) is limited to the premium received at the time the option is sold, the risk is unlimited . To enter an uncovered call trade, you’ll need the highest option approval level available at Schwab (Level 3) and must have substantial funds to meet the higher margin requirements of this strategy.

Long puts

As with a long call trade, a long put trade is fairly straightforward. Again, these can be difficult to trade profitably, but they can serve as a foundation for more complex option strategies.

A long put option is a bearish strategy, like shorting a stock, insofar as you’re assuming a share’s price will fall enough in the future to be worth agreeing beforehand to sell at a certain price. Unlike a short stock position, however, you generally have to be right about more than just the direction of the stock to be profitable. As with long calls, you will usually need to be right about the direction, the magnitude and the timeframe of the stock price movement.

Here are a few other things about put options to keep in mind:

  1. Put options tend to move in the opposite direction as the underlying instrument, whether up or down, though the moves are usually of a smaller magnitude.
  2. The higher the strike price, the higher the value.
  3. As with calls, put options also tend to lose a small amount of value with each day that passes on the way to expiration.
  4. Put values are also based in part on expected volatility, and as a result, the lower the anticipated volatility, the lower the option value.

As with any options strategy, before you decide to enter a long put trade, be sure to find the maximum gain, maximum loss and breakeven points. The formula for these calculations on a long put trade is as follows:

  • Long 1 XYZ Jan 50 Put @ $3
  • Maximum gain = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)
  • Maximum loss = $300 (3.00 option premium paid x 100 shares per contract)
  • Breakeven point = 47 (50 strike price – 3.00 option premium)

Figure 4. Long Put Profit or Loss Visualization

Source: Schwab Center for Financial Research

As you can see in Figure 4, while the maximum potential loss on a long put trade is the price paid for the option, the profit potential as the stock drops in price is significant. Keep in mind that because the option has a limited lifespan, the move in the underlying security needs to happen before expiration and be big enough to cover the cost of the option. It also needs to be sufficient to offset the erosion in time value and possibly even changes in volatility. These characteristics of the trade make it more difficult than one might think to profit from the position.

Short puts

While short puts (also known as cash secured puts or naked puts) are not quite as risky as short calls, they are still not a strategy for inexperienced option traders or traders without substantial risk capital. Selling a put creates a profit-or-loss scenario that is exactly the opposite of long put. Here’s an example:

  • Short 1 XYZ Jan 50 Put @ $3
  • Maximum gain = $300 (3.00 option premium received x 100 shares per contract)
  • Maximum loss = $4,700 (50 strike price – 3.00 option premium x 100 shares per contract)
  • Breakeven = 47 (50 strike price – 3.00 option premium)

Figure 5. Short (Cash Secured or Naked) Put Profit or Loss Visualization

Source: Schwab Center for Financial Research

Note: Chart depicts strategy at expiration.

A short put trade can be an extremely risky position because while the profit (if the stock rises in price) is limited to the premium received at the time the option is sold, the downside risk increases the closer the stock gets to zero.

To enter a cash-secured short put trade, you’ll need the lowest option approval level available at Schwab (Level 0), and also sufficient cash available in your account to meet the potential assignment obligation. To enter a naked short put trade you’ll need not only the highest option approval level (Level 3), but you must also have substantial funds to meet the high margin requirements of this strategy.

Selecting your strike price

Traders who are new to options are usually quick to understand the risk/reward characteristics. But traders often have difficulty deciding what strike prices to use. Whether the strike price is in the money (ITM), at the money (ATM) or out of the money (OOTM) will affect the magnitude of the underlying move needed to reach profitability (or help you determine whether the trade can be profitable if the underlying stock remains unchanged). The tables below (Figures 6 and 7) illustrate how to properly structure a long or short option trade to match your level of bullishness or bearishness.

For example, if you are extremely bullish , you may want to consider out-of-the-money long calls or in-the-money short puts. Keep in mind, both will generally require a very large bullish move in the underlying stock or index in order to reach profitability. In contrast, if you are only slightly bullish, you may want to consider in-the-money long calls or out-of-the-money short puts, the latter of which can sometimes be profitable with no movement in the underlying stock.

Figure 6. Bullish Options Strategies

Bullish Neutral Breakout Bearish Extreme Moderate Slight Long call OOTM X X Long call ATM X X Long call ITM X X Uncovered (naked) puts OOTM X X X Uncovered (naked) puts ATM X X Uncovered (naked) puts ITM X X

Source: Schwab Center for Financial Research

In the same manner, if you are extremely bearish you may want to consider out-of-the-money long puts or in-the-money short calls. Keep in mind, both will generally require a very large bearish move in the underlying stock or index to be profitable. In contrast, if you are only slightly bearish, you may want to consider in-the-money long puts, or out-of-the-money short calls, the latter of which can sometimes be profitable with no movement in the underlying stock.

Figure 7. Bearish Options Strategies

Bullish Neutral Breakout Bearish Extreme Moderate Slight Long puts OOTM X X Long puts ATM X X Long puts ITM X X Uncovered (naked) calls OOTM X X X Uncovered (naked) calls ATM X X Uncovered (naked) calls ITM X X

Source: Schwab Center for Financial Research

As with most option strategies, the greater the underlying move needed, the higher the profit potential—and the less likely it is that any profit will be made. In the case of out-of-the-money short puts and short calls, because profitability is possible with no movement in the underlying stock, the potential profit will likely be small. And the risk on these trades is extremely high, which is why I generally don’t recommend them. The use of credit spreads involves far less risk while generally providing only slightly less profit potential.

Another important concept to understand is that when you pair stocks and options, your sentiment on the underlying stock does not change (see Figure 8). You are simply using the option leg of the strategy to hedge your position or to help generate additional income.

Figure 8. Pairing Stocks and Options

Primary position Market sentiment Secondary position Rationale for adding options
Long stock Bullish Long put Buying downside protection
Short stock Bearish Long call Buying upside protection
Long stock Bullish Short call Extra income
Short stock Bearish Short put Extra income

Source: Schwab Center for Financial Research

In summary, you can take either a bullish or bearish position on an underlying instrument—a stock, an exchange-traded fund (ETF) or an index—using either calls or puts. What you use simply depends upon whether you buy or sell them first.

What You Can Do Next

Learn more about options trading at Schwab.

Call 877-807-9240 to speak with a Schwab options trading specialist.

Schwab clients: Find out about getting approved to trade options.

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