Binary Option Pricing The 4 Factors that Impact Your Trading

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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

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.

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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)

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)

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)

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.

Factors That Determine Option Pricing

Options can be used in a wide variety of strategies, from conservative to high risk. They can also be tailored to meet expectations that go beyond simple directional strategies. So, once you learn basic options terminology, it makes sense to investigate factors that affect an option’s price in various scenarios.

Key Takeaways

  • Options are derivative contracts the right, but not the obligation, to buy (for a call option) or sell (for a put option) some asset at a pre-determined price on or before the contract expires.
  • Options can be used for directional strategies or to hedge against certain risks in the market.
  • Pricing an option relies on complex mathematical formulas, but the direct inputs into an option’s price include the price of the underlying asset, the option’s strike, time to expiration, interest rates, and implied volatility.

Using Options For Directional Strategies

When stock traders first begin using options, it is usually to purchase a call or a put for directional trading, in which they expect a stock will move in a particular direction. These traders may choose an option rather than the underlying stock due to limited risk, high reward potential and less capital required to control the same number of shares.

If the outlook is positive (bullish), buying a call option creates the opportunity to share in the upside potential without having to risk more than a fraction of the market value. If bearish, buying a put lets the trader take advantage of a fall without the margin required to sell short.

Market Direction And Value

Many kinds of option strategies can be constructed but the position’s success or failure depends on a thorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options requires a new way of thinking because traders who think solely in terms of market direction miss all sorts of opportunities.

In addition to moving up or down, stocks can move sideways or trend modestly higher or lower for long periods of time. They can also make substantial moves up or down in price, then reverse direction and wind up back where they started. These kinds of price movements cause headaches for stock traders but give option traders the exclusive opportunity to make money even if the stock goes nowhere. Calendar spreads, straddles, strangles and butterflies highlight a few option strategies designed to profit in those types of situations.

Basics of Option Pricing

Option traders need to understand additional variables that affect an option’s price and the complexity of choosing the right strategy. Once a stock trader becomes good at predicting the future price movement. he or she may believe it is an easy transition from options but this isn’t true. Options traders must deal with three shifting parameters that affect the price: the price of the underlying security, time and volatility. Changes in any or all of these variables affects the option’s value.

Option pricing theory uses variables (stock price, exercise price, volatility, interest rate, time to expiration) to theoretically value an option. Essentially, it provides an estimation of an option’s fair value which traders incorporate into their strategies to maximize profits. Some commonly used models to value options are Black-Scholes, binomial option pricing, and Monte-Carlo simulation. These theories have wide margins for error due to deriving their values from other assets, usually the price of a company’s common stock. There are mathematical formulas designed to compute the fair value of an option. The trader simply inputs known variables and gets an answer that describes what the option should be worth.

The primary goal of any option pricing model is to calculate the probability that an option will be exercised, or be in-the-money (ITM), at expiration. Underlying asset price (stock price), exercise price, volatility, interest rate, and time to expiration, which is the number of days between the calculation date and the option’s exercise date, are commonly used variables that are input into mathematical models to derive an option’s theoretical fair value.

Key Pricing Inputs

Here are the general effects that variables have on an option’s price:

1. Underlying Price & Strike Price

The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value because you are able to buy the underlying asset at a lower price than where the market is, and puts should decrease. Likewise, put options should increase in value and calls should drop as the stock price falls, as the put holder gives the right to sell stock at prices above the falling market price.

That pre-determined price at which to buy or sell is called the option’s strike price or exercise price. If the strike price allows you to buy or sell the underlying at a level which allows for an immediate profit buy disposing of that transaction in the open market, the option is in-the-money (for example a call to buy shares at $10 when the market price is currently $15, you can make an immediate $5 profit).

2. Time to Expiration

The effect of time is easy to conceptualize but takes experience before understanding its impact due to the expiration date. Time works in the stock trader’s favor because good companies tend to rise over long periods of time. But time is the enemy of the buyer of the option because, if days pass without a significant change in the price of the underlying, the value of the option will decline. In addition, the value of an option will decline more rapidly as it approaches the expiration date. Conversely, that is good news for the option seller, who tries to benefit from time decay, especially during the final month when it occurs most rapidly.

3. Interest Rates

Like most other financial assets, options prices are influenced by prevailing interest rates, and are impacted by interest rate changes. Call option and put option premiums are impacted inversely as interest rates change: calls benefit from rising rates while puts lose value. The opposite is true when interest rates fall.

4. Volatility

The effect of volatility on an option’s price is the hardest concept for beginners to understand. It relies on a measure called statistical (sometimes called historical) volatility, or SV for short, looking at past price movements of the stock over a given period of time.

Option pricing models require the trader to enter future volatility during the life of the option. Naturally, option traders don’t really know what it will be and have to guess by working the pricing model “backwards”. After all, the trader already knows the price at which the option is trading and can examine other variables including interest rates, dividends, and time left with a bit of research. As a result, the only missing number will be future volatility, which can be estimated from other inputs

These inputs form the core of implied volatility, a key measure used by option traders. It is called implied volatility (IV) because it allows traders to determine what they think future volatility is likely to be.

Traders use IV to gauge if options are cheap or expensive. You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that the current IV is high or low. Once understood, the trader can determine when it is a good time to buy options – because premiums are cheap – and when it is a good time to sell options – because they are expensive.

The Bottom Line

Options are complex, but their price can be described by just a handful of variables, most of which are known in advance. Only the volatility of the underlying asset remains a matter of estimation. Once you have a firm grasp of the essentials, you’ll find that options provide flexibility to tailor the risk and reward of every trade to your individual strategies.

How Does Implied Volatility Impact Options Pricing?

Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a mutually agreeable price on or before a specified future date. Trading these instruments can be very beneficial for traders. First, there is the security of limited risk and the advantage of leverage. Secondly, options provide protection for an investor’s portfolio during times of market volatility.

The most important thing an investor needs to understand is how options are priced and some of the factors that affect them including implied volatility. Option pricing is the amount per share at which an option is traded. Although the option holder is not obligated to exercise the option, the seller must buy or sell the underlying instrument if the option is exercised.

Learn more about options, and how volatility and implied volatility work in this market.

Key Takeaways

  • Option pricing, the amount per share at which an option is traded, is affected by a number of factors including implied volatility.
  • Implied volatility is the real-time estimation of an asset’s price as it trades.
  • When options markets experience a downtrend, implied volatility generally increases.
  • Implied volatility falls when the options market shows an upward trend.
  • Higher implied volatility means a greater option price movement can be expected.

Options

Options are financial derivatives that represent a contract by a selling party—or the option writer—to a buying party—or the option holder. An option gives the holder the ability to buy or sell a financial asset with a call or put option respectively. This is done at an agreed price on a specified date or during a specified time period. Holders of call options seek to profit from an increase in the price of the underlying asset, while holders of put options generate profits from a price decline.

Options are versatile and can be used in a multitude of ways. While some traders use options purely for speculative purposes, other investors, such as those in hedge funds, often utilize options to limit risks attached to holding assets.

Options Pricing

An option’s price, also referred to as the premium, is priced per share The seller is paid the premium, giving the buyer the right granted by the option. The buyer pays the seller the premium so he has the option to either exercise the option or allow it to expire worthless. The buyer still pays the premium even if the option is not exercised, so the seller gets to keep the premium either way.

Consider this simple example. A buyer might pay a seller for the right to purchase 100 shares of Company X’s stock at a strike price of $60 on or before May 19. If the position becomes profitable, the buyer will decide to exercise the option. If, on the other hand, it does not become profitable, the buyer will let the option expire, and the seller gets to keep the premium.

There are two facets to the option premium: The option’s intrinsic value and time value. The intrinsic value is the difference between the underlying asset’s price and the strike price. The latter is the in-the-money portion of the option’s premium. The intrinsic value of a call option is equal to the underlying price minus the strike price. A put option’s intrinsic value, on the other hand, is the strike price minus the underlying price. The time value, though, is the part of the premium attributable to the time left until the option contract expires. The time value is equal to the premium minus its intrinsic value.

There are a number of factors that affect options pricing including volatility, which we’ll look at below.

Other factors that affect options pricing include the underlying price, strike price, time until expiration, interest rates, and dividends.

Implied Volatility

Volatility, in relation to the options market, refers to fluctuation in the market price of the underlying asset. It is a metric for the speed and amount of movement for underlying asset prices. Cognizance of volatility allows investors to better comprehend why option prices behave in certain ways.

Two common types of volatility affect option prices. Implied volatility is a concept specific to options and is a prediction made by market participants of the degree to which underlying securities move in the future. Implied volatility is essentially the real-time estimation of an asset’s price as it trades. This provides the predicted volatility of an option’s underlying asset over the entire lifespan of the option, using formulas that measure option market expectations.

When options markets experience a downtrend, implied volatility generally increases. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates that greater option price movement is expected in the future.

Another form of volatility that affect options is historic volatility, also known as statistical volatility. This measures the speed at which underlying asset prices change over a given time period. Historical volatility is often calculated annually, but because it constantly changes, it can also be calculated daily and for shorter time frames. It is important for investors to know the time period for which an option’s historical volatility is calculated. Generally, a higher historical volatility percentage translates to a higher option value.

Option Skew

Another dynamic to pricing options, particularly relevant in more volatile markets, is option skew. The concept of option skew is somewhat complicated, but the essential idea behind it is that options with varied strike prices and expiration dates trade at different implied volatilities—the amount of volatility is uniform. Rather, levels of higher volatility are skewed toward occurring more often at certain strike prices or expiration dates.

Every option has an associated volatility risk, and volatility risk profiles can vary dramatically between options. Traders sometimes balance the risk of volatility by hedging one option with another.

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