Regardless of whether we are betting or trading in binary options or fixed odds, time is always draining away in one way or another, and if we are on the ‘wrong side’ of an event happening, then time moves ever faster against us.If we are on the right side, time is working in our favor. This is one of the issues we have to overcome when trading such instruments, and as we saw above, one of the ways we can do this is by using the ‘in running’ feature which allows us to enter the event when we feel the probability/time relationship is more in our favor.
Another is to understand volume and price and to use this knowledge to forecast future market behavior with confidence, of which more later.In the world of vanilla options (those options quoted on a central exchange such as the CME), time is just as important, but here there is one critical difference. As a vanilla options trader you can buy and sell options.
In the world of exotic or binary options you only have the choice to purchase the proposition, either to accept or reject the event. In other words select an option on an event happening, or not happening.In the vanilla world, in selling an option you are getting time to work in your favor, and it is no longer working against you. This is absolutely fundamental and is why so many professional traders opt to sell options rather than buy them.
Why? Simply because these traders understand time is a wasting asset, and as a seller they are using time to their advantage, and to the disadvantage of the option buyer on the other side. Furthermore, it is also generally accepted that between 80% and 85% of options expire worthless, and the reason is time works for the option seller, but against the option buyer. In the binary world we are option purchasers, agreeing or disagreeing with the proposition, and therefore need to be acutely aware of this and the immense power of time erosion.
This is not to say we cannot use time to our advantage when trading binary options – we can. As you will discover later, to get time on our side it is a question of timing and the associated probabilities. Think of this in terms of betting in running where the favorite in a horse race is well ahead in the final furlong of the race. Here we are putting time on our side since there is little time left before the end of the race. It is the same with a binary option.
If we are prepared to accept a very small return on the probability of an event happening, time in this case is working for us as the event is near to expiry. And the same principle can be applied if we are betting on an event not happening.At this point I am very conscious of the fact that I have used the terms odds and probabilities as almost interchangeable, which strictly speaking they are not.
Therefore, let me correct this now, so we can move on to look at some real examples, and explore the odds, probabilities and returns in more detail.In some ways, in talking about odds and probabilities, this in itself also defines the crossing point between the fixed odds world of sports betting and the binary world of trading. Odds are more generally associated with racing and fixed odds, whilst probabilities are now associated with binaries.
But what is the difference?In a sense very little, as they are both attempting to describe the chance of an event happening or not. Using odds, this is expressed in terms of success or failure. In other words, the number of desired outcomes compared to the number of undesired outcomes. Using probability this is calculated as the number of desired outcomes compared to the sum of possible outcomes.If we start with probability, and take a simple example of rolling a dice. Suppose we want to know the probability of throwing a three on a dice.
The maths are as follows: Number of desired outcomes = 1 (we want a three)
Sum of possible outcomes = 6 (6 numbers on the dice)
The probability is therefore 1/6 = 0.1666666 recurring
This is then usually converted to a percentage and the probability becomes 0.16666666 x 100 = 16.67%
Another simple example would be the toss of a coin. Suppose we want to know the probability of the coin landing as a head:
Number of desired outcomes = 1 (we want a head)
Sum of possible outcomes = 2 (head or tail)
The probability is therefore 1/2 x 100% = 50%
To be precise, in this case there is a third outcome which we have ignored here. The coin could theoretically land on its edge. This is very unlikely, but nevertheless possible, and in the world of betting and binary options it happens. And it’s called a dead heat.