Pairs Trading for Binary Options

In this article, we will discuss a highly effective binary options trading strategy: pairs trading. This method allows you to diversify your assets and trade two or more assets simultaneously with the aim of minimizing risk and maximizing trading profits.

Topics covered:

1. How does pairs trading work?

2. Pairs trading with a single underlying asset

3. Pairs trading with competing assets

How Does Pairs Trading Work?

Pairs trading is a strategy whose profitability does not depend on the direction of the market. It is therefore considered market-neutral. The method involves identifying price correlations between two underlying assets that are related in some way—for example, the price of iron and the share prices of steel companies. When the price of a particular commodity crashes, related stocks sometimes decline disproportionately. In our example, however, steel company shares rose slightly despite the drop in iron prices.

The principle behind pairs trading is reflected in its name. The method involves trading binary options in pairs by opening positions in opposite directions. It can be used with either one asset or multiple assets. This approach resembles a straddle or strangle, but it does not necessarily involve a single financial instrument.

Advantages of pairs trading:

• Investment protection;

• High profitability;

• Risk minimization.

Pairs trading can be applied to any underlying asset, including currency pairs, stocks, and commodities. There are two approaches to this type of trading: using a single asset or two competing assets.

Single-asset pairs trading for binary options involves purchasing PUT and CALL contracts on the same instrument at different times. Pairs trading with competing assets, meanwhile, involves purchasing CALL and PUT contracts on different instruments.

The mechanics of pairs trading are incredibly simple, but the method requires experience and the ability to analyze the market quickly—especially when trading competing assets.

Pairs Trading with a Single Underlying Asset

You can choose any underlying asset for this type of pairs trading, although binary options traders typically use Forex pairs or shares of popular companies. The paired trades are opened at different times but share the same expiration time. This creates a price range that can help minimize losses and potentially double profits. For the method to be profitable, both trades must have the same investment amount and expiration time.

Example: Suppose an investor purchases a CALL option on the EUR/USD currency pair with a 60-minute expiration. They invest $1,000 at an entry price of 1.3308. An in-the-money (ITM) option offers a 75% return. The broker also offers a 15% refund if the option expires out of the money. If the trade is successful, the investor earns $750 in profit. Otherwise, the broker returns only $150.

Forty-five minutes after the option is purchased, the asset's price reaches 1.3365, and the option is in the money. However, risks remain. With 15 minutes left until expiration, market conditions could change dramatically. Concerned about a pullback, the trader decides to open a second trade.

To do this, they purchase a PUT contract on the same underlying asset, EUR/USD. They must use the same parameters as for the original CALL trade. The investment amount and expiration time must also match. The second trade creates a new window of opportunity between 1.3308 and 1.3365. If the price finishes within this range, the investor earns $1,500 ($750 + $750). In other words, pairs trading in this situation has helped protect the investment and double the profit.

By opening the second trade, the investor also minimizes risk. If the price finishes outside the specified range at expiration, the loss will be significantly smaller. Suppose the investor did not purchase the CALL contract and EUR/USD closed below 1.3308. The loss would then be $850, since the broker would refund 15%, or $150.

Fortunately, a second trade was opened in our example. As a result, the loss was reduced from $850 to $100. Here is how it works:

If the price is above 1.3365 at expiration, the first trade finishes in the money, while the second finishes out of the money. The total payout from the first trade is $1,750 ($1,000 + $750), while the second returns $150 as a 15% refund. Together, these amounts total $1,900—just $100 less than the initial investment of $2,000 ($1,000 per trade). The resulting loss is therefore only $100, compared with the $850 loss in the first scenario.

The same outcome occurs if the first trade finishes out of the money and the second trade is successful.

Pairs Trading with Competing Assets

This type of strategy was developed to profit from movements in the share prices of two companies that operate in the same sector and compete directly with each other. Examples include Apple/Samsung, Microsoft/Sony, AMD/Intel, and others.

Here is how this approach works with binary options:

Suppose you believe Microsoft shares are about to fall sharply. You would then take a bearish position on the tech giant's stock. Purchase a PUT option with a strike price of $500, expecting Microsoft's share price to decline. Set the expiration to 60 minutes and invest $1,000. The return will be 75% if the trade finishes in the money. The broker will also refund 15% if the option finishes out of the money.

Even if you open the trade after analyzing the market and feel 100% confident in your forecast, it still carries risk: you can earn only $750 if the trade succeeds, but you could lose up to $850 if it fails. In a volatile market, share prices can move significantly in either direction. Even the most experienced investor cannot guarantee that a trade will finish in the money.

Trading competing pairs can increase your chances of making a profit by taking advantage of the effect Microsoft's actions have on a direct competitor. This is the most challenging stage of the strategy because it requires a thorough understanding of the markets. You need to identify which companies stand to benefit most from Microsoft's difficulties. For example, its competitor Sony could rise. Anticipating this, the trader purchases a CALL option on the Japanese company's shares. All option parameters, including the expiration time and investment amount, must match.

By purchasing options linked to Microsoft and Sony share prices, the investor minimizes risk. If both forecasts are correct, the profit doubles. The investment is protected because one trade complements the other. In addition, the risk amounts to $850 − $750 = $100, just as it does when trading a single asset. This is considerably better than the original risk of losing $850.

Summary

Market-neutral strategy — a trading method whose profitability does not depend on the direction of the markets.

Pairs trading — a market-neutral strategy based on identifying price correlations between multiple financial assets.