In this example there are several key points to note, and perhaps the first is whilst this is a ‘static’ schematic, if you were looking at this in real time the probabilities on the right hand side would be changing constantly, reflecting the constant changes in the underlying contract. And, if this looks a little complicated it is in fact very straightforward, and more so than its equivalent in the vanilla options world.
In vanilla options we have calls and puts which can be both bought and sold, in effect two ladders side by side. In the binary options world we only have one ladder, but many of the techniques and strategies you will learn here can also be applied to vanilla options. I hope in discovering binary options, you will then be keen to learn more about vanilla options.
I will be publishing a book about trading vanilla options in the near future, as I have always found options a fascinating subject and instruments which can offer traders a huge amount of flexibility in their trading. However, I digress. Back to our binary options ladder, and please remember this is only a hypothetical schematic and the ladder may differ depending on the platform you are using.
We will take a look at the Nadex platform shortly, but the essential elements will be the same.Starting on the left we have the market being offered, which in this case is the S&P 500 index, and also specified is the underlying contract. This is important. If you remember when we looked at off exchange bucket shops, one of the many issues was that of price transparency.
As a trader you have little or no idea of where or how the broker is delivering the price, and more importantly how much these prices are likely to be manipulated at expiry. In trading with an on exchange broker these issues do not arise. Here you know precisely what price is being quoted, and the instrument. In this example it is the underlying futures contract for December.
I will also explain how the price is calculated at expiry from the underlying, once we start to dig a little deeper into the Nadex platform and consider the entire process from start to finish.Next comes the strike price. This is the price which defines the yes/no outcome of the binary option. The symbol > is simply a mathematical symbol meaning ‘greater than’. It is short hand for writing the binary option proposition.
Here you can see we have a range of strike prices in the ladder, which are stepping up in 3 point intervals from 1828 at the bottom to 1855 at the top. These intervals are set by the exchange, and will generally be equal increments, reflecting the market and instrument being traded. By contrast, it would be unrealistic to have a spot forex ladder moving higher in 3 pip increments as this would make the ladder unwieldily.
The increments reflect the average range for each instrument in the timeframe being quoted, and are set accordingly, to provide a balance of deep out of the money, deep in the money, and at the money options. Perhaps you can begin to see how elegant options can be as a trading instrument. No longer are we considering the simple prospect of a market rising or falling.
Here we have a range of contracts which we can trade according to our risk appetite, and even more important, gives us the ability to construct various trading strategies.The strike price is the defining price for our option. If the strike price quoted for that option is > 1840.0 (to close greater than 1840.0), then the index must close above this price at expiry for the option to settle at 100. If it is at or below this price the option will settle at 0.
The strike price is the fulcrum of the option, and is the point at which the probability is 50. If you are agreeing with the proposition, above the strike price the option is moving into the money, and below the strike price the option is moving out of the money. Conversely, if you are disagreeing with the proposition, then below the strike price your option is moving into the money and above the strike price is moving out of the money.
Next comes the date and time of the expiry. This specifies the precise time and date at which the option expires and settles either at 100 or 0. Finally on the right hand side we have the bid and the offer, the spread of the probability if you like. And as we have done before, by simply taking the mid point this will give us an overview of where the underlying market is trading. By looking at the bid/offer column on the right we can see immediately the index is probably trading around the 1840 price level, since this is around the 52.50 mid-point probability.