What Are Ladder Options

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Ladder Option

What Is a Ladder Option?

A ladder option is an exotic option that locks in partial profits once the underlying asset reaches predetermined price levels or “rungs.” This guarantees at least some profit, even if the underlying asset retraces beyond these levels before the option expires. Ladder options come in put and call varieties.

Do not confuse ladder options, which are specific types of options contracts, with long call ladders, long put ladders, and their short counterparts, which are options strategies that involve buying and selling multiple options contracts simultaneously.

How a Ladder Option Works

Ladder options are similar to traditional option contracts that give the holder the right, but not the obligation to buy or sell the underlying asset at a predetermined price at or by a predetermined date. However, a ladder option adds a feature that allows the holder to lock in partial profits at predetermined intervals.

These intervals are fittingly called “rungs” and the more rungs the price of the underlying asset crosses, the more profit locks in. The holder keeps profits based on the highest rung achieved (for calls) or the lowest rung achieved (for puts) regardless if the price of the underlying crosses back below (for calls) or above (for puts) those rungs before expiration.

Because the holder earns non-returnable partial profits as the trade develops, total risk is much lower than for traditional vanilla options. The trade-off, of course, is that ladder options are more expensive than similar vanilla options.

Example of a Ladder Option

Consider a ladder call option where the underlying asset price is 50 and the strike price is 55. Rungs are set at 60, 65, and 70. If the underlying price reaches 62, the profit locks in at 5 (rung minus strike or 60 – 55). If the underlying reaches 71, then the locked in profit increases to 15 (new rung minus strike or 70 – 55), even if the underlying falls below these levels before the expiration date.

As with vanilla options, there is time value associated with ladder options. Therefore, the traded price for call options is usually above the locked in profit amount, and declining as the expiration date approaches.

If the price of the underlying falls below any of the triggered rungs, again for calls, it almost does not matter to the price of the option because the partial profit is guaranteed. Although, this is an oversimplification because the lower the underlying moves below the highest triggered rung, the less likely it will be to rally back to exceed that rung and reach the next rung.

Ladder Options – Trading Binary Options Ladders

Ladder options trading is somewhat similar to boundary (or range) options. While in boundary options two limits are provided – one upper limit and one lower limit, with ladder options, there are generally five price limits (the exact number will vary depending on the broker and the asset).

These limits are not always distributed symmetrically to the current price level. It means that all five limits can be below the current price level or 3 limits can be higher than the current price level and 2 can be lower, for example. The limits are generally traded in both up and down directions – but not always.

All the price limits have two options to trade with – ‘Above’ or ‘Below’ (maybe represented as ‘Call’ or ‘Put’ by some binary options brokers). Each limit will have a different payout percentage for the ‘Above’ and ‘Below’ options. The percentage depends on the likelihood of the prediction finishing ‘in the money’ (being correct). If the possibility of the prediction being true is high, the percentage payout will be small and vice versa. This is how ladder options can generate payouts reaching 1000% and above, the high payout reflect the low probability of them finishing in the money.
The limits – or ‘rungs’ – are defined by the brokers and cannot be changed. The expiry time can however, be altered. As the expiry time is amended, there is a corresponding change in the limits and their payout potential.

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Ladder option – Example

Look at the screenshot below. On the right are a range of values – each has it’s own ‘Above’ and ‘Below’ payouts figure.

The payout amounts are relative to the $25 entered in the amount field. Each ‘rung’ on the ladder is a different value, and each requires a certain price movement from the actual asset price. The greater the price move required, the larger the payout. In the image, AUD/USD is trading at 0.7403. If you expect a big price spike, you can select “above” on the 0.74112 level and get a whopping 374% return if you are right.

The the mid-level option, has payouts of 47% for ‘below’ and 79% for ‘above’. The options at the very top and very bottom have only one option available – above at the highest point, and below at the lowest. The broker deems the other outcomes so likely, they are not willing to trade them at all.

Why Trade Ladder Options?

One of the attractions of binary options, is the simplicity. Some traders might argue that ladder options introduce a layer of complexity that moves away from that ‘ease of use’ and are therefore to be avoided. That view misses some key points;

  • Ladder options offer some huge payouts, relative to other trade types
  • Ladders provide options during volatile markets
  • Where traders expect large swings in price, a ladder provides higher profitability than a standard binary option
  • Ladders are fundamentally no more complicated than a traditional option
  • High frequency, low risk / low payout trades are possible with ladders.

The last point is worth expanding. In the above screenshot, the price level of 0.73992 can be traded above for 7.79% – Not a huge payout, but if a trader was confident that the rise from this resistance level was assured, it is a quick, low risk route to profit.

Winning Ladder Trades

Trading ladder options requires market awareness and some research. Although the same is true for other trading styles as well, these factors are extremely important for ladder trading. It is possible to win the biggest payout only if one is able to get a prediction correct which had low probability. A steep rise/fall is needed for an extreme prediction to be correct. This may happen if some important event related to the asset takes place. An interest rate announcement or profit warning from a major firm for example, may cause a large and sudden price correction. Traders need to stay aware of all the events to win high payout trades.
Similarly, high frequency trades for lower payouts rely on reduced volatility. The higher strike rate required means mistakes must be few and far between.

Ladder binary options offer another route for a trader to profit, but they need to be fully understood. They can be used as hedging tool or specialised in, in their own right. Not ever binary options broker will offer ladders – prices and payouts need to be constantly updated. So choose any potential broker wisely, and if ladders seem like an interesting avenue for profits, make sure the right broker is selected.

Ladder Option Strategy

Ladder options offer the highest payouts of all binary options types. To trade them effectively, you need a good strategy. This article introduces you to three great strategies for ladder options.

The three strategies which you will learn in this article are:

  1. Trading ladders based on the ATR & moving average crossovers
  2. Using the ATR & the ADX to make negative predictions
  3. Trading resistance and support levels with ladder options

With these three strategies, you will know three very different approaches to ladder options. By understanding the spectrum of possibilities, you learn to adjust our strategies to your preference and create the ideal strategy for you.

Strategy 1: Trading Ladders With ATR And Moving Average

When you trade a ladder option, you face two challenges:

  1. Predicting the market’s direction, and
  2. Predicting the market’s range.

Tackling both challenges with the same tool is difficult. This is why this strategy uses two tools – one for each prediction.

Predicting the market’s direction with moving averages

Moving average crossovers are perfect for predicting the market’s direction. Moving averages calculate the average price of the last periods and repeat this process for all periods in your chart. They then draw the results directly into a chart, which creates a line.

This line moves slower than the market:

  • When the market is in an uptrend, the moving average will be based on periods that are lower than the current market price. The moving average will be higher than the market, too.
  • When the market is in a downtrend, the moving average will be based on periods that are higher than the current market price. The moving average will be higher than the market, too.

When the market changes direction, it switches from being on one side of the moving average to the other, which means that it has to cross the moving average. Consequently, the market’s crossing of the moving average is a significant event that indicates a change market direction.

This is the perfect event for our strategy.

  • When the market crosses the moving average upwards, invest in a ladder option that predicts rising prices.
  • When market crosses the moving average downwards, invest in a ladder option that predicts falling prices.

Now that you have the direction, you only need to predict the market’s potential range. This is why you need the ATR.

Predicting the market’s range with the ATR

The Average True Range (ATR) is a volatility indicator. It measures the true average distance the market has moved per period in the past.

Let’s use the example from our basic text on ladder options. Assume that you are trading the AUD vs. JPY currency pair with a current price of 91.226. The expiry of your ladder option is 1 hour. The ATR has a value of 0.1 on a 10-minute chart, which tells you that the asset has moved an average of 0.05 over the last periods. This value allows you to predict how far the market can move and which target price you should use for your ladder option.

Let’s assume that the asset has just crossed your moving average upwards and you want to invest in rising prices. Your broker offers you these target prices for your ladder option:

Name Price Limit Above Payout Below Payout
Price Level 1 91.200 54.23% 92.62%
Price Level 2 91.245 90.89% 55.44%
Price Level 3 91.291 158.29% 31.47%
Price Level 4 91.337 280.34% 11.32%
Price Level 5 91.382 530.43% 1.00%
Price Level 6 91.425 1011.23% 0.00%

Which of these target prices is the best choice for a ladder option? Let’s go through them one by one.

  1. Price level 1 (91.2) is lower than the current market price (91.226). Since you are predicting an upwards movement, this would be a very safe prediction. It would, however, also limit your payout to 54.23 percent. This is not profitable enough.
  2. Price level 2 (91.245) is above the current market price (91.226), but not by much. In a market that moves at a speed of 0.05 per period, it would take the market less than one period to reach this price. Since you are expecting an upwards movement, this is still a very safe prediction. It would get you a payout of 90.89 percent, which is better than price level one, but it is still not a lot.
  3. Price level 3 (91.291) is about 1.5 times the ATR’s value (0.05) away from the current market price (91.226). This sounds interesting. Remember: to win your ladder option; the market has to trade above the target price one hour from now. You have six periods until this happens (60-minute expiry, 10-minute chart). Not all periods of a movement point in the same direction, which is why the market is unlikely to reach a target price six times as far away as the ATR’s value. But a target price in a distance of 1.5 times the ATR’s value with a payout of 158.29 percent seems like a relatively safe bet to make a nice profit.
  4. Price level 4 (91.337) is a little more than two times the ATR’s value from the current market price (91.226). In an upwards movement, the market is still likely to reach this target price. This prediction is a little riskier than price level 3, but it gets you almost twice the payout – 280.34 percent. Most traders would prefer this investment.
  5. Price level 5 (91.382) is a little more than three times the ATR’s value from the current market price (91.226). This is a risky prediction. The market would have to move in the right direction for four out of five periods. If you are right, though, you get an insane payout of 530.43 percent, which means that winning one-quarter of your trades would still turn you a profit. Risk takers prefer this target price.
  6. Price level 6 (91.425) is more than four times the ATR’s value from the current market price (91.226). This prediction is too risky. While you would get a great payout of 1011.23 percent, there is almost no chance that the market reaches this target. It would have to move in the right direction for an entire hour. Stay away from this prediction.

With these assessments, the ATR has helped you to distinguish the target prices.

  • If you like to play it safe, use price level 3.
  • If you like to take risks, use price level 5.
  • Traders who are looking for a nice mix of risk and potential take price level 4.

Trade this strategy for a while and monitor your success. You will find that you prefer a certain ratio of target price distance and ATR. In our example, the ATR has a value of 0.05 and there are six periods until the option expires. If all periods pointed in the same direction, the market would move about 0.3. Some traders like a target price that is about half this distance from the current market price. They would invest in price level 5. Other traders might prefer a target price that is one-third this distance away, which would lead them to invest in price level 3.

Find your own perfect ratio, and you will be able to quickly and easily use the ATR to pick the right price level for your ladder option.

Strategy 2: Using The ATR & The ADX

In our previous example, we used the ATR to make positive guarantees – we predicted which price levels the current movement can reach. With this strategy, we want to do the opposite: we want to predict which price levels are out of the reach of the current movement.

We can accomplish this goal without the moving average. There is no need for a signal; we just want to know whether a price level is currently out of reach. Instead, we need a little more precision, which is why we need the average directional movement index (ADX).

Let’s use the same example as earlier: you are looking at a 10-minute chart of the AUD vs. JPY currency pair with a current price of 91.226. Your broker offers you these target prices for a ladder option with an expiry of 60 minutes:

Name Price Limit Above Payout Below Payout
Price Level 1 91.200 54.23% 92.62%
Price Level 2 91.245 90.89% 55.44%
Price Level 3 91.291 158.29% 31.47%
Price Level 4 91.337 280.34% 11.32%
Price Level 5 91.382 530.43% 1.00%
Price Level 6 91.425 1011.23% 0.00%

Since we are now making a negative prediction, we have to focus on the below payout. The important question is which price level the market can reach and in which price level it makes sense to invest. Let’s look at each price level:

  1. Price level 1 (91.200) is below the current market price (91.226). This is a bad investment. When you get payouts like these, your broker expects the market to move upwards. Otherwise, they would not offer such high payouts for below predictions. Therefore, there is no sense in investing in falling prices.
  2. Price level 2 (91.245) is above the current market price (91.226), but not by much. Predicting that the market will trade below this price level only makes sense when the ATR has a spectacularly low reading, for example01. Anything else, and this prediction would be too risky. With a payout of 55.44 percent, you have to win more than 65 percent of your trades, so this price level is not worth the risk.
  3. Price level 3 (91.291) is further from the current market price (91.226) but still very close. This price level would be a possible investment if the ATR’s value were very low, for example02. The payout of 31.47 percent is interesting for a negative prediction, but you need to know that you are making a safe prediction here.
  4. Price level 4 (91.337) allows you to make a safe prediction in most market environments. Even if the ATR read 0.3, the market would be unlikely to trade above this price level when your option expires. Some traders would even trade this value with an ATR at 0.4, but the relatively low payout of 11.32 percent requires you to make a safe prediction that can win you a high percentage of your trades.
  5. Price levels 5 and 6 (91.382 and 91.425) offer payouts of 1 percent and 0 percent, respectively. There is no sense in trading such payouts.

The point of this is that is difficult to choose the perfect price level based on the ATR alone. In most market environments, you could safely trade price levels five and six, but their low payouts make these price levels unprofitable. All other price levels require you to mix risk and potential. To know how to mix these factors, you need another tool. This tool is the Average Directional Movement Index (ADX).

The ADX evaluates the market’s directional strength on a scale from 0 to 100. Most traders interpret readings under 20 as a lack of direction and reading above 40 as a strong direction. These values help you to estimate which target price you should use for your ladder option:

  • If the ADX reads more than 40, be careful. When the market has such a strong direction, you have to plan for the worst. Assume that all periods before your option expires point in the same direction and pick the price level with the highest payout outside of this reach. In our example, there are six periods until your option expires. Price level 3 (91.291), for example, is 0.65 from the current market price (91.226). When the ATR reads less than 0.1, this is the price level to choose.
  • If the ADX reads less than 20, go for it. When the market lacks direction, it is time to get the high payouts. Risk-takers might even invest in a price level that is only as far as the ATR’s reading from the current market price, traders with a medium risk tolerance should use a target price that is twice as far as the ATR’s reading. In our example, this means that risk takers could even invest in price level 2 when the ATR reads 0.05, which is a relatively high value. All others should decide between price levels 3 and 4. When the ATR has a lower reading, all traders can choose price level 2.
  • If the ADX reads between 20 and 40, take moderate risks. When the market has a medium strength of direction, your risk should be medium, too. Pick an approach somewhere between the two examples above. When the ATR reads 0.02, for example, most traders will invest in price level three, which is a secure prediction but still gets a payout of 31.47 percent.

You might also exclude one or two of these market environments from your strategy. Risk-averse traders might only invest in this strategy when the ADX reads less than 20.

Strategy 3: Trading Resistance / Support With Ladder Options

This strategy is ideal for traders who like visual signals more than mathematical calculations. Resistance and support levels are important price levels that the price of an asset is unable to break.

For example, assume that an asset has been trading for around £99. It has tested the £100 barrier a few times but always failed to break through it. In this case, the £100 barrier becomes a resistance. Similarly, when an asset has traded for around £101 but failed to fall below £100, the £100 barrier becomes a support level.

In both cases, there seems to something that stops the asset from breaking through the £100 wall. You will never know what exactly stops the market, but this is unimportant. Apparently, traders are no longer willing to buy (in the case of a resistance) or sell (in the case of a support) the asset for £100.

This is all you need to trade a ladder option. When the market approaches a resistance line, you wait until the first target price with a reasonable payout comes within reach. Your definition of a reasonable payout is up to you. Most traders would want at least 30 percent, better 50 percent payout before they invest.

Should the market move closer to the resistance/support, you might be able to invest in the same resistance/support with a higher payout. Most traders would use this opportunity to make more money with the same prediction.

If the market breaks through a resistance or a support, you will lose all your options. You can make up for the lost money, though. When the market breaks a resistance/support, it has freed itself and is likely to move strongly. This is the ideal environment to invest in a ladder option that predicts a strong movement. You should be able to easily win a ladder option with a payout of 200 percent, which can make up for your losses.

Ladders – Summary

Ladder options allow for a variety of potential strategies. Depending on your risk tolerance and whether you prefer positive or negative predictions, you should tailor your strategy along the lines of the three strategies which we laid out. The possibilities are endless, but you now know where to start.

The Financial Engineer

Ladder option

Long Call Ladder

The long call ladder, or bull call ladder, is a limited profit, unlimited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience little volatility in the near term. To setup the long call ladder, the options trader purchases an in-the-money call, sells an at-the-money call and sells another higher strike out-of-the-money call of the same underlying security and expiration date.

Long Call Ladder Construction
Buy 1 ITM Call
Sell 1 ATM Call
Sell 1 OTM Call

The long call ladder can also be thought of an extension to the bull call spread by selling another higher striking call. The purpose of shorting another call is to further finance the cost of establishing the spread position at the expense of being exposed to unlimited risk in the event that the underlying stock price rally explosively.

Limited Profit Potential

Maximum gain for the long call ladder strategy is limited and occurs when the underlying stock price on expiration date is trading between the strike prices of the call options sold. At this price, while both the long call and the lower strike short call expire in the money, the long call is worth more than the short call.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Lower Strike Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls
Long Call Ladder Payoff Diagram

Limited Downside Risk, Unlimited Risk to the Upside

Losses is limited to the initial debit taken if the stock price drops below the lower breakeven point but large unlimited losses can be suffered should the stock price makes a dramatic move to the upside beyond the upper breakeven point.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Loss = Price of Underlying – Upper Breakeven Price + Commissions Paid

Breakeven Point(s)

There are 2 break-even points for the long call ladder position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $35 in June. An options trader executes a long call ladder strategy by buying a JUL 30 call for $600, selling a JUL 35 call for $200 and a JUL 40 call for $100. The net debit required for entering this trade is $300.

Let’s say XYZ stock remains at $35 on expiration date. At this price, only the long JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial debit of $300, selling this call to close the position will give the trader a $200 profit – which is also his maximum possible profit.

In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The short JUL 35 call will expire with $1500 in intrinsic value while the short JUL 40 call will expire with $1000 in intrinsic value. Selling the long JUL 30 call will only give the options trader $2000 so he still have to top up another $500 to close the position. Together with the initial debit of $300, his total loss comes to $800. The loss could have been worse if the stock had rallied beyond $50.

However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his loss will be the initial $300 debit taken to enter the trade.

Note: While we have covered the use of this strategy with reference to stock options, the long call ladder is equally applicable using ETF options, index options as well as options on futures.

Short Call Ladder

The short call ladder, or bear call ladder, is an unlimited profit, limited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience significant volatility in the near term.

Short Call Ladder Construction
Sell 1 ITM Call
Buy 1 ATM Call
Buy 1 OTM Call

To setup the short call ladder, the options trader sells an in-the-money call, purchases an at-the-money call and purchases another higher strike out-of-the-money call of the same underlying security and expiration date.

Limited Downside, Unlimited Upside Profit Potential

Maximum gain for the short call ladder strategy is limited if the underlying stock price goes down. In this scenario, maximum profit is limited to the initial credit received since all the long and short calls will expire worthless.

However, if the underlying stock price rallies explosively, potential profit is unlimited due to the extra long call.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Total Strike Prices of Long Calls – Strike Price of Short Call + Net Premium Received
  • Profit = Price of Underlying – Upper Breakeven
Short Call Ladder Payoff Diagram

Limited Risk

Losses are limited when employing the short call ladder strategy and maximum loss occurs when the stock price is between the strike prices of the two long calls on expiration date. At this price, the higher striking long call expires worthless while the lower striking long call is worth much less than the short call, thus resulting in a loss.

The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Lower Strike Long Call – Strike Price of Short Call – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying is in between the Strike Prices of the 2 Long Calls

Breakeven Point(s)

There are 2 break-even points for the short call ladder position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Total Strike Prices of Long Calls – Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Point = Strike Price of Short Call – Net Premium Received

Example

Suppose XYZ stock is trading at $35 in June. An options trader executes a short call ladder strategy by selling a JUL 30 call for $600, buying a JUL 35 call for $200 and a JUL 40 call for $100. The net credit received for entering this trade is $300.

In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The long JUL 35 call will expire with $1500 in intrinsic value while the long JUL 40 call will expire with $1000 in intrinsic value.

Buying back the short JUL 30 call will only cost the options trader $2000. So selling the long calls and buying back the short call will leave the trader with a $500 gain. Together with the initial credit of $300, his total profit comes to $800. This profit can be even higher if the stock had rallied beyond $50.

However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his profit will only be the initial credit of $300 received.

On the other hand, let’s say XYZ stock remains at $35 on expiration date. At this price, only the short JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial credit of $300, buying back this call to close the position will leave the trader with a $200 loss – this is also his maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the short call ladder is equally applicable using ETF options, index options as well as options on futures.

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