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September 16, 2014

Binary Options 101

I recently came across some discussion about binary options which piqued various curiosities within my market psyche enough to spur some investigation. My first impression of these instruments is akin to what one may experience walking into a local bookie's office. And while I do not believe these instruments have any place in a serious trader's repertoire, I thought I would share my insight to hopefully spur some discussion or the sharing of any tales of woe or success.

First and foremost, assigning the name "option" to these binary instruments may be a bit generous. The trader neither has the right to deliver nor to demand delivery of the underlying instrument. The option label stems from the fact that these instruments have a strike price and and expiration date, but the similarities with traditional options end there.

The "binary" descriptor comes from the fact that only two possible values exist for an option at expiration. If the option is in the money, its final value is $100... no matter how far ITM the underlying settles. Any option at or out of the money has a final value of zero.

The binary characteristic of outcomes make both pricing and potential returns on binary options very interesting. These options will basically trade at a price that reflects the probability for the underlying asset to be ITM at expiration, and the probabilistic nature of pricing (as opposed to value pricing) changes the way we must think about time value and volatility premiums.

Traditional options hold an intrinsic value (which can be zero for OTM options) as well as a premium for time and implied volatility. The time premium will be greater the further away from expiration the options sits. With binaries, however, time premium can be positive, negative, or zero.

For example, a binary option that sits at-the-money always trades for $50 (with a spread for the market makers, of course) no matter how much time remains until expiration. The market is basically saying that the chances for a given asset to finish ITM is a coin toss for any point in time at which price is ATM. A trader's perception of these odds based on technical analysis may differ, providing a perceived opportunity for arbitrage.

Time value gets really interesting when an option is not ATM. Consider an option that is comfortably in the money with a couple of days remaining until expiration. This option may trade at $80, reflecting a strong possibility that price will remain ITM until expiration. Now suppose that only a couple of hours remain until expiration, and the price of the underlying has not changed. The option may now sell for $95. Why? Because less time remains for price to move OTM, hence a higher probability for the option to expire ITM. All else held equal, the option gains value with time. In other words, in-the-money binary options carry a negative time value (they are less valuable with distance from expiration).

The opposite is true for OTM binaries: the further away from expiration an OTM binaries sits, the more time the option has to move ITM, hence a higher time value. So, OTM binaries carry a positive time value.

The story with volatility is similar. All else held equal, higher volatility will decrease the value of an ITM binary since more volatility increases the chances of knocking price below the strike. Likewise, higher volatility will increase the value of an OTM binary... a positive volatility premium for OTM binaries and a negative premium for ITM binaries.

Still, the math tempts many traders into a gambling trap. For example, a binary call that is significantly OTM may sell for $10, reflecting a 10% chance of seeing the underlying instrument close ITM. A trader risks $10 to make $90. A bit of hubris may tempt a trader into believing he can be right more frequently than one in ten times.

At least with a bit of technical analysis, a trader may be able to make a case for some frequency of success, but event binaries, which allow people (I will not call them traders in this case) to bet on results such as whether an employment release will be above or below a certain number, are just pure dice rolls.

Perhaps some of you can identify mispricings that can be arbitraged, but for the rest of us, satisfying the gambling urge can be much more efficiently executed with the purchase of a weekly lottery ticket. You will lose money much more slowly, and although the odds of success are tremendously slimmer, a win would be more meaningful to your lifestyle.

I certainly hope someone out there got the pun in the title.


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