First, time erosion increases exponentially. It is not linear as the effects increase dramatically the closer we are to expiry.Second, as we move along the time axis, and towards expiry the probability of the event not being true tends to 0, and the probability of the event being true tends towards 100. We saw both of these effects in Fig 4.10. Each time the price revisited a similar price level the probability above the centre line was rising, and the probability below the centre line was falling. The exponential aspect was also reflected in this schematic and the associated probabilities as follows:
Option proposition: True Early in life 50/54 – 58/62 or 52% to 60% Late in life 76/80 – 92/96 or 78% to 94%
Option proposition: False Early in life 42/46 – 34/38 or 44% to 36% Late in life 24/28 – 8/12 or 26% to 10%
Early in the life of the option a similar move saw the probabilities change from a difference of (60% – 52%) 8% initially, then moving on subsequent price action to (94% – 78%) 16% for a true outcome at expiry.
For a false outcome again these have changed dramatically from (44%-36%) 8% to (26% – 10%) 16%. The change in probabilities is reflecting the increasing speed of time erosion on the probability of the event happening or not happening. In other words whether the outcome is ultimately true or false at expiry.
The third and final effect at work here is that of volatility, which we are going to consider in great detail and its relationship to the underlying price action. But the point I want to highlight here in relation to expiry and time is as follows.Remember the nature of the instrument we are trading here.It cannot be both. The binary will close at expiry at either 0 if false or 100 if true.
This in turn means unlike other instruments, a tiny price move close to expiry can induce extremely volatility and fast moving changes in probabilities. Suppose the option is based on the price of an index to be above a certain level by 3 pm. It is 2.59 pm and the price is one point below, but then moves one point above and then back below. Within that simple price action, which would normally pass unnoticed, there will be massive spikes in the probabilities moving from very low through 50% up to very high, and then back again.
All in the space of a few seconds. This is the power of time at its most devastating as the contract moves close to expiry. A tiny price move can have a huge effect on the probability since the option has to close at either 0 or 100.And one of the key trading decisions you will have to make with every binary option is whether to hold until expiry.
Of course, with an on exchange binary option this decision is made much easier for you, as you always have a choice when to exit the market. There is no requirement to hold until expiry. It is your decision. But remember if you do, and the option is very close to the proposition price, then you will see some wild swings in the probabilities on very small price moves.
There is a further aspect of volatility and it is where volatility is created from the underlying price action. Here it is much better news and is where on exchange binary options really come into their own, once we start to consider some simple binary option trading strategies.In The Money – Out Of The Money:A concept which is very familiar to vanilla options traders, but perhaps less so to binary option traders is the notion of an option being in the money, at the money or out of the money.
What does this mean? Once again let’s start with a simple schematic as shown in Fig 4.12 where price is shown on the Y axis and time on the X axis.Fig 4.12 – Binary option ITM, ATM, OTM There are only three ‘states’ an option can be in relation to the underlying instrument, and these are referred to as in the money (ITM), at the money (ATM), and out of the money (OTM).
At any time in the life cycle of an option it is in one of these three conditions, and this applies to both binary and vanilla options although the interpretation in binary options is very different.In the binary options world we are dealing with a single instrument, and only considering whether a proposition is true or false. In other words whether something is going to happen or not.
In the vanilla options world we have a myriad of choice and associated strategies. For a binary option the state of an option will depend on whether we are agreeing with the proposition or are disagreeing. In the first case, an ITM option will be above the option proposition line, and in the second it will be below. In other words in Fig 4.12, we are considering an example where we are in agreement with the proposition of the binary option, and as the probability moves above the mid point, then it moves into the money (ITM) and below this line it is (OTM) out of the money.