Binary Risk Reversal

Implied volatility in SPX is finally coming down a lot and option prices are starting to become decent again. However the next time we are in a similar situation of high IV and expensive options and we want to play upside we can use a binary risk reversal. Remember that a normal risk reversal is:

RR = short put + long call 

The idea is to finance the expensive call with an even more expensive put that we are selling. This is actually a fantastic trade in any market with strong trend to the upside, however the drawback is that the short put is naked and it is exposing us to major risk in case of big downside.

So a good solution is to create a binary risk reversal like this:

BRR = short binary put + long binary call

In this case because we switched the put to a binary put our downside risk exposure is well defined, in other words SPX could go to zero and the risk remains the same for us. Because there are no liquid binary options in SPX traded in the US we can replicate the position with the following:

BRR = short vertical put spread + long vertical call spread

Where the width of the spread is as small as possible, in the case of SPX we use verticals 5 points wide. Remember that a binary option is just a vertical spread at the limit of a width that tends to 0.

Binary option = lim width ->0 vertical spread

In the case of SPX a width of 5 points represents 0.18% of notional so a 5 point vertical is actually a very good approximation to a pure binary option.

What we are looking here is at the correct strikes for the spread. The idea is to pick the long one around our target area (for DLA trades it can be 1% up from current level) and the short put spread can be very near the ATM level so it provides a fat credit.

If we get the chance to perform one of these trades I'll cover them in more detail. I just wanted to provide some background information about them for those of you that were curious when I mentioned the possibility of doing one.

Leo Valencia hosts the Gamma Optimizer options service at ElliottWaveTrader.net.