Just like regular vanilla options, binary options have option chains. These chains show you all the possible conditions that you can speculate on.In other words, you can bet on the price of the underlying to be above or below a wide range of prices. Typically, strike prices are available roughly two times the average daily range for daily options and two times the average weekly range for weekly options.
The higher the probability of a condition to occur by expiration, the less your payout odds are on your trade. For example, if you are to forecast the underlying’s going up 50 points by expiration, you may have to put up only $5 to win $100. However, if you speculate for the underlyingsimply not to drop by 50 points until expiration, you may have to bet $95 to win just $5. Of course, in the second example you are much more likely to win than you are in the first example, which is why the odds available to you are much lower.
Please keep in mind that we are using arbitrary numbers in these examples. They are not an actual reflection of what any underlying would be doing, and they are not connected to any option chain.Exhibit 3.8 illustrates the payout odds based on the probability of a move. Exhibit 3.9 is an example of an option chain of the US 500 binary options strike prices with 12 hours until expiration. In Exhibit 3.9, the S&P futures (US 500) are trading at around 1225.
If you want to speculate that the US 500 is going to close above 1297.5 by expiration, you can purchase your option at the ask price of $6.5. The price of the option is relatively cheap since, historically, it is fairly unlikely that the S&P futures will jump up above the strike price by expiration.Exhibit 3.10 is the profit‐and‐loss (P&L) graph of going long the 1297.5binary option.
The x‐axis depicts the price of the underlying asset, and the y‐axis depicts profit and loss. The 1297.5 binary option is considered outof-the-money. The chances of the S&P futures moving 72 points and closing above 1297 are very small, and therefore the payout is high. Since the S&P futures are trading at 1225.5 during the snapshot of the option chain, the 1225.5 option has an ask price of 55.5 and a bid price of 51. The reason for this is that the strike price and the price of the underlying are very close to each other.
When this occurs, there is a roughly 50 percent chance that the underlying will go above or below its actual price by expiration and therefore the binary options price gives you roughly 1‐to‐1 odds, meaning you bet $55.5 to win $44.5 for a reward to risk ratio of .802:1 (44.5/55.5).Exhibit 3.11 is the P&L graph of going long the 1225.5 binary option.
The x‐axis depicts the price of the underlying asset and the y‐axis depicts profit and loss.There is roughly a 50 percent likelihood of the S&P futures closing above 1225.5 and therefore the payout reflects this.If you believe that the underlying will not go down significantly, you can purchase the 1177.5 strike price for $88. When you make this purchase,as long as S&P futures do not drop by 47.5 points to 1177.5, the option will settle at $100 and you will turn your $88 into $100, meaning you bet $88 to win $12 for a reward to risk ratio of .136:1
(12/88).Exhibit 3.12 depicts the profi t and loss of going long the US 500 binary option with a strike price of 1177.5. In this example, the 1177.5 binary option is in‐the‐money, and the chance of the S&P futures going down 47.5 points is relatively small; therefore, the payout is much less than the previous examples. The x‐axis depicts the price of the underlying asset and the y‐axis depicts profi t and loss.