Binary Option Pricing

An overview of unique strategies
Binary Option Pricing

Are you a regular Binary Option trader? How profitable is your trading? These are questions which no doubt go to the core of any dedicated trader.

What we at the trading club have noticed is that traders who are trading options these days are not necessarily using strategies that take advantage of Binary Option Pricing. More particularly, they do not take a view on the various components of this price.

Why simply trade the trend on the EUR/GBP when you can take advantage of underlying movements in the volatility, time to expiry and strike to shape your strategy?

Of course, Binary Options pricing can be quite a complicated procedure. Indeed, most online resources will point people to explanations which involve advanced derivative mathematics like the black Scholes model. These are mainly used by OTC traders at global investment banks.

This, however, should not deter you. If you can understand the main components of a Binary Options price, then you are best positioned to make a profit from the movements in these variables.

Short Overview of Binary Options

As many will now know, a binary is a unique type of option that has only two payoffs. These are either 0 or 100 on most platforms. Of course, the pay-out can technically be a number other than 100 but we are keeping it at this level for simplicity sake.

The trader enters the option and will get the pay-out if the option expires in the money and will lose the entire initial investment if it expires out of the money. Whether the current price is above or below the strike at expiry and how it impacts “money-ness” is a function of whether the option was a call or put option.

You can read more about what Binary Options are if you would like to understand these concepts more concretely before continuing.

Components of a Binary Option Price

Black Scholes Binary Option

What is important to note about Binary Options is that they are merely a variant of traditional American options with a Binary Payoff. As such, they are impacted by the same components and inputs as traditional American options.

If you are vaguely familiar with Option pricing then you will know that it is normally determined by a function called the Black Scholes model. As complicated as it may look, one merely needs to understand that the function has a number of inputs. The main inputs of this function are no doubt the current price, the volatility in the underlying price and the in the time to expiry.

Hence, if either of these inputs changes, it will most likely have an impact on Binary Option pricing. As such, this is the opportunity for the astute trader to make extensive returns and improve their performance.

How Likely is a Win?

A great deal of binary option pricing and trading comes down to probability theory. How likely is it that the option will expire in the money and hence pay-out? This probability will impact on the price someone is willing to pay for a Binary Option in the market. The more certain the traders are that the option will end in money, the closer there are willing to pay to the 100 pay-out number.

All of the components that we have mentioned above will impact on the probability that the option will end in the money at expiry.

Using an actual example, assume that there is a Binary Option which has a pay-out of 100 with an expiry in the money. The current price of the option is at 30. If the option expires in the money, the pay-out will be 70. This implies that the chance of the option expiring in the money is only 30%.

Current Price (S)

Black Scholes Binary Option

This is probably one of the factors that most greatly impacts binary option pricing. This is because where the current price is will determine whether the option has expired in-the-money and whether the trader has won.

Therefore, it also impacts on the probability of an expiry in-the-money if there is still time till expiry. For example, taking a look at a CALL option. If the current price is above the strike then the price of the option is likely to be above 50 to reflect the increased probability that it will expire in-the-money.

Similarly, on the flip side if the price of the underlying is considerably below the strike, there is a reduced probability that it will expire in the money and hence a lower option price to reflect this.

If we wanted to take a look at an example that involved actual option pricing, let’s say that you wanted to enter a GPB/JPY binary CALL option with expiry in 2 hours. The strike price of the option (K) is at 140.50 and the current GBP/JPY level is at 142. This implies that the option is more likely than not to expire in the money and hence it will demand a price above 50.

This does assume that the other two components that we will mention below are held constant.

Volatility (σ)

Black Scholes Binary Option

In traditional option pricing, volatility (σ) drives the price as well. In fact, in big Investment banks, the option traders are termed the “volatility traders” and these traders only take views on the movement of the volatility and not necessarily the price.

Indeed, volatility is quite a complex discipline to understand. There are different classifications such as implied volatility, realised volatility, and volatility on volatility. However, for the average Binary Options trader, all you have to understand is that the volatility is a measure of how quickly and regularly the underlying asset moves in price.

For the trader, this is an important component. It means that the option may quickly swing into the money before expiry even if it is currently below the strike price. Similarly, it could also impact on the price of an option that is in-the-money. This is because there is also a chance that it could move out of the money and lose.

If you were a trader who wanted to trade the asset’s volatility, how would you go about it? You could make a relative value trade on the volatility implied by the option price and that which is currently prevailing in the market.

For example, let us assume that there is an asset which usually moves about 18 points in a day. However, currently the market is relatively quiet and its maximum movement over the past few hours was only 8 points. This means that if the option is in the money, you can enter the Binary Option at a relative bargain as it is unlikely to swing out-of-the money and result in a losing trade.

Time to Expiry (T-t)

Black Scholes Binary Option

We are all aware of the old adage that “time is money”. In option land, that also holds true and in many cases time to expiry (T-t) is termed the “time value” of the option.

Coming back to probability calculation that the trader makes, the time to expiry adds uncertainty to the calculation. This is indeed true for many other things in life. The more time that we have the more certain we are of reaching an end goal. This could be completing assignment or reaching a destination on a trip.

When someone is pricing a binary option, the time the option has to expire will impact on their mental calculation of whether they will win the trade. For example, if the binary option is currently out of the money and is 30 seconds to expiry, you can be fairly certain that it will expire and you will lose the trade.

However, if there was still 12 hours to go to expiry then there is still enough time for the option to move into the money before expiry.

How might the Binary Option trader enter a trade based on the time to expire? Given the unique nature of a Binary Option payoff, a chance for large payoffs is possible when the option is near expiry. For example, if the price of the option is quite near the strike price and near expiry, there is the chance of a large swing in the price as it approaches the “all or nothing” payoff.

Taking a look at the above example of the GBP/JPY, if the strike is at 140.50 and the current price is equal to the strike, there is an almost 50% chance that it will either payoff 0 or 100 in a very short period of time. Hence, a trader who strategically enters the option near expiry can make a rather impressive return on the trade.

A Comprehensive Approach

Of course, the astute trader will not merely look at only one component and trade solely based on that. Each of these factors have an impact on binary option pricing to varying degrees dependent on the underlying asset. One can think of them as three legs to a chair. Each as is important as the other and a trader needs to make a careful analysis of the relative impact of each on the option price.

Moreover, the really successful trader will combine use these factors in a comprehensive trading strategy. This should include a strategy that includes technical analysis with binary option signals and fundamental analysis of Economic conditions.

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