Expiry and time are two of the fundamental concepts you have to understand as an options trader, whether in the world of binary or vanilla options. These concepts are very familiar to options and futures traders, but less so to those who have never traded these instruments. We did touch on these concepts in an earlier chapter, but it is at this point I want to consider them in much greater depth, so you can understand the nature of the instrument you are trading.
Whilst binary options appear superficially simple, beneath that simplicity lies a web of sophistication and complexity, and it is these aspects we are going to cover now. If you have already dabbled in the options market, you will know that many traders like to buy options which are cheap.It is because they have little or no chance of ever making money for the holder of the option.
They are cheap for one reason, and one reason only. The probability of the underlying market moving in their favor is extremely low. The difference in the binary options market is you will see these probabilities quoted, so there is no maths involved. Through the quote notation the market is giving you its verdict on whether the option has a high, medium or low probability of making money. But herein lies the danger.
Far too many binary options traders take the same approach as in the vanilla options market, simply viewing a low probability option as a low cost/low risk proposition which has the potential to deliver a very high return.Whilst probabilities can and do swing wildly from one extreme to the other (as you will see shortly), you have to understand the reasons why.
On occasion this might be the right strategy to adopt, but it is one that has to be adopted for the right reasons. Understanding the effects of expiry and time will help you make logical decisions based on your analysis of the underlying chart, which is always the starting point.In trading any option, whether binary or otherwise, you are essentially trying to forecast whether something will happen or not in a given period of time.
In other instruments and markets this is not the case. As a spot forex trader you may have taken a long position in the GBP/USD, but you can keep that position open for as long as you wish, or until your stop loss takes you out. As a trader you would be managing that position, locking in profits and making discretionary decisions on staying in or closing out.A binary option is very different. It has a physical expiry date and time.
If the event has happened at expiry the binary option closes at 100. If it has not happened then it closes at 0. As you will see on the Nadex platform these expiry dates and times can be intra hour, hours, days or weeks, and this is one of the many advantages of trading options. If you are time limited in your life because of work or family commitments, you can trade the longer term options easily without needing to be in front of your screen all day, and of course any risk is both limited and known.
Let’s examine the typical behavior of a binary option as it moves from inception to expiry, using the schematic shown in Fig 4.10. This could be in any market, as it is the concept I am trying to convey here.In Fig 4.10 I have created what I hope is a simple schematic to explain some of the key concepts you will need to be aware of when considering a binary option. The schematic is not perfect, but I hope conveys the essential elements in a simple and visual way.
The first point, which is perhaps self evident, is that every binary option quotation is based on an underlying market. This may be either the spot market, the cash market or the futures market, and this is always your starting point as a binary options trader. It is very easy to forget this in the rush to open a position based purely on the probabilities being quoted. This is completely the wrong approach.
Your starting point should always be your chart analyzed in multiple timeframes. This is then backed up by the fundamental and relational aspects of your analysis, all of which are explained in my other books.The schematic in Fig 4.10 is designed to show you the ‘life cycle’ of a binary option. The X axis is time, and the Y axis is price. The actual timeframe under consideration is irrelevant here as the relationships we are about to discuss will apply regardless of whether this is an intraday, daily or weekly binary option.
The same fundamental principles will apply. In this example, the binary option has opened on the left and moves towards expiry on the right. The centre line is the axis around which the binary option oscillates. It is the fulcrum, the balancing point at which the probability of the event occurring or not is always 50%. In this case we are considering an option in which the proposition is that it will close above this level at expiry.