› Covered Call Binary Option Strategy - How It Works

Covered Call Binary Option Strategy - How It Works

Market conditions change rapidly as every trend requires healthy retracements. After reaching a certain price level, the underlying asset could have a short-term against-the-trend action due to several reasons such as profit-taking flows, momentum exaggeration or sudden changes in the fundamental environment. Although the main tendency is usually kept in the long run, and markets reverse at some point, renewing the long-term trend, short-term fluctuations could have a significant impact on the overall efficiency of the trading system. Especially for such cases, binary options traders invented a Covered Call Options trading strategy.

What is a Covered Call?


Covered Call Strategy based on a simultaneous buying of call and put options with different expiration periods.
Typically, a call option is bought with a longer expiry during a sustainable uptrend of the underlying asset, while buying put options with a shorter expiry is possible during micro-downtrends. At the same time, when the general trend was determined as bearish and the underlying asset is declining during a long-term period, binary options traders buy put options within longer timeframes and call options with shorter expiration time when the market is retracing.

This strategy is sometimes marketed as being "safe" or "conservative" and even "hedging risk" as it provides premium income, but its flaws have been well known at least since 1975 when Fischer Black published "Fact and Fantasy in the Use of Options".

How to Use a Covered Call in Options Trading?


Imagine a trader bought a call option for Facebook shares with 24-hours expiration time. However, quotes chart an intraday reversal signal on 15-minutes chart in the middle of the trading session. Technical indicators point to a possible reversal action or retracement required for the buyers of call options to regain the momentum, while short-term oscillators have to be reloaded, coming off the overbought territory after a sharp price swing.

In that case, it would be attractive to open a series of deals, buying put options with 15-minutes expiration until the opposite reversal signal occurred. As a result, the trader would still hold the call options previously bought following the long-term trend with a high chance of getting the profit at the end of the day. At the same time, the counter-trend correction gives a chance to maximize potential profits, implementing the intraday trading approach and catching a micro-trend.

Another application of the Covered Call Options Strategy is related to intraday conditions influencing a sudden reversal of the underlying asset price. For example, that might happen in case if an announcement was published, shifting the traders’ sentiment and influencing a sharp sell-off in the middle of the trading session. Even though the overall trend remained the same at the end of the day, using Covered Call Options would hedge the trader from possible risks coming together with unpredictable price fluctuations.

Covered Call Max Profit


The number of inner trading positions is not limited as traders can keep holding a call option with 24-hours expiration. The trader starts buying put options on 60-minutes charts and enlarges the number of deals opened on 15-minutes timeframes. Once the micro-trend in the opposite direction is over, it would be reasonable to assess chances for the initial trading position to get in the money depending on current quote levels. If the primary option profit is in danger of losses, traders can increase the volume for short-term deals based on intraday technical sentiment. As a result, such a technique allows increasing the flexibility of the intraday trading strategy, increasing the overall efficiency of the trading system at the end of the day.

Managing the trading volume


The trading volume has to come in line with the individual trading strategy and money management rules. Traders should not exceed a certain maximum level of simultaneously opened positions. With that in mind, binary options traders should arrange a trading plan for every session, using what-if conditions to create the algorithm. The trading volume for every particular timeframe has to be predetermined, while the maximum length of the trading cycle has to be limited in order to avoid too much pressure on the account balance. In most cases, the initial entry is made with the largest volume, while intraday Covered Call Option has to have a lower volume as the number of deals will be increased. That gives traders an advantage to adopt trading algorithms to changing market conditions, hedge from possible risks, and maximize the total profit at the end of the day.

Covered Call Example


The technical analysis on the daily chart below points to a long-term uptrend for the price of gold. After a short-term retracement, gold prints a strong by-the-trend action of the daily candlestick marked with the green arrow on the screenshot (August 25). The intraday price action is consistent and gradual, the strength of the underlying asset is robust. It would be reasonable to continue the trading cycle of buying call options on the other day as well, and imagine a trader opened the appropriate deal on August 26.

[sup]If you like this strategy, you might also be interested in this Hanging Man

Covered Call Binary Option Strategy - How It Works

The next day, however, brings a sudden change in the technical sentiment. The intraday chart has a clear reversal signal on a one-hourly timeframe (see the chart below). The 14-hours Relative Strength Index comes off the extremely overbought level, Commodity Channel Index confirmes the previous signal, charting a bearish divergence. As a result, the technical analysis points to a short-term retracement of the underlying asset and the trader starts buying put options with 60-minutes expiry although the 24-hours call option is still in play. The total number of red hourly candlesticks is comparatively large, and the overall profit from covered options is robust. Once the micro-trend ends and the price reverses the action, closing the day with a minimal gain, the initial deal ends in the money as the daily candlestick is green. Thus, the trader took profits from both calls and put options opened simultaneously with different expiration periods.

Covered Call Binary Option Strategy - How It Works

Conclusion


Although the long-term trading strategy is more significant in terms of determining trends, binary options traders might consider changing the direction of the cycle within shorter periods, implementing the wide variety of Covered Call Strategies. The main advantage is that such a trading approach allows traders to be more flexible in light of rapidly changing market conditions. At the same time, catching micro-trends opposite to the main direction of the underlying price is reasonable if the technical analysis has appropriate signals. For example, buying call options with 4-hours expiration does not take too much time in terms of the trading activity, while at some points, the technical sentiment could offer a trading opportunity to buy put options on the 15-minutes chart. Taking profits from both directions of the quotes fluctuations allows traders not only to maximize potential profits but also to hedge themselves from a possible risk related to unpredicted shifts in the market sentiment.


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