If the binary is based on the market being higher than a certain price level by expiry, then once the option has moved beyond this level it is considered to be in the money (ITM). It has some ‘price value’ by virtue of the option having a higher probability of closing with a ‘true’ result.In this case if the option is below the option proposition it is considered to be out of the money or (OTM).
A binary option which is at the 50% level is considered to be at the money or (ATM). Finally, one of the terms used a great deal when considering this aspect of options is to refer to them as ‘deep in the money’ – a high probability of being true, and conversely ‘deep out of the money’ – a high probability of not being true.However, the question is this. Do probabilities and in the money or out of the money dynamics always go hand in hand?
And the answer is no, most definitely not, and to find the reason why we have to go back and think about time.If you recall from our example earlier with seconds to go to expiry, the probabilities were swinging wildly from deep in the money, to deep out of the money. In other words the probabilities would be swinging from 90% through to 50% and down to 5%, perhaps very fast. And the reason? Time and imminent expiry.
In this case the high probability is not signaling a binary option that is deep in the money, but merely a high probability the option will expire as true at that second. This is very different from the concept we are discussing here.In considering whether a binary option is ITM or OTM it is price we need to consider first. A binary option which has a high probability such as 90% and where the price is well above the option proposition can then be considered as deep in the money.
In this case the option may be 50 or 60 points above the option proposition, and is therefore reflecting two things. First, a high probability the option will expire true, and second the option has price value as it is now in the money.This is a key distinction. A binary with a high probability or a low probability does not automatically mean it is deep in the money, or deep out of the money. We need to check the price level as well.
If the price is well above or below the option price proposition, then we can deduce the option has strong ‘price value’ or weak ‘price value’ which then confirms the probabilities being quoted on the binary.I cannot stress this point too strongly. It is too easy to view the probability on a binary option as the only criteria for gauging whether the event will close at 100 or 0. It is not, and must always be viewed in the context of the underlying price.
Consider the two examples here:95% probability on an index with 2 minutes to expiry with a proposition target price of 2100 and with the index trading at 2101 95% probability on an index with 2 minutes to expiry with a proposition target price of 2100 and with the index trading at 2120 The probability being quoted is the same, yet the first has virtually no price value, since the high probability is as a result of the time and expiry relationship.
The probability in the second is a deep in the money option with high price value. The only difference between the two is the underlying price and its relationship to the proposition target price.In summary, never assume the probability reveals the complete picture for a binary option. It may not for the reasons explained above.
This is a concept you need to be aware of as a binary options trader, and why trading binaries is far more complex than simply deciding whether a market is likely to rise or fall. The ‘value’ of the option as dictated by the time to expiry and the price will be an important one along with several other factors.A further notion which moves on from the above, is the relationship between probability, time and price and is one many option traders struggle to grasp.
And perhaps the easiest way to explain this relationship is with two simple examples.In our first example, suppose we have agreed with the binary option proposition which is deep in the money and is now at 85%. There is still some time to expiry, and the price of the underlying asset is well above the option proposition expiry price. The question is this. Does the market have to move for the binary option to close at 100%? The answer is no, it does not. All we have to do is wait, and time will do the rest for us.
If the market didn’t move at all, we already know time is a wasting asset, and as we approach expiry works exponentially. This is what I was referring to earlier when I explained the power of time. Time erosion can work both for us as option traders, and against us. In this example we are using its power to ‘run down the clock’ on the option to expiry.