Anything is possible. This is why a binary option is quoted in probabilities. But on balance this option is deep in the money with the index trading well above the strike price of 1828, and with a current probability of 85.75. However, with time eroding fast this option will increasingly tend to 100, even if the price does nothing and simply remains where it is at present.At the other end of the binary ladder, we have a deep out of the money option with a strike price of >1855.
With the index trading around the 1840 price level the underlying futures contract would have to move a considerable way, 15 points or more and quickly, for this option to have any chance of closing above this price. This is why the probability is being quoted at 9.5. First, it is very unlikely the market will move this far in such a short space of time. Second, time erosion is working against the binary. Third the binary is already tending to zero as these factors increase their effect as expiry approaches.
These are the two extremes on the binary option ladder, but as you can see there are other propositions to choose from, all with varying degrees of risk attached, as defined by the probability being quoted in the bid and the offer. These will be changing constantly as the underlying market moves accordingly.Throughout the above example we have considered the ITM and OTM notation through the prism of agreement with the proposition. If we viewed the ladder through the prism of disagreement with the proposition, the statements above would be reversed.
Here for example we could disagree with the proposition the strike price of >1855 will be achieved, in which case this would then be considered an in the money option viewed from that standpoint, not greatly in the money, but in the money nevertheless, since the probability of the event happening is very low.Before we round off on the ladder, it is also important to realize your binary options broker will offer a huge array of option ladders for each instrument with a variety of expiry dates and times.
Some will be hourly, or even shorter, whilst others will be longer intra day, end of day, weekly and even monthly. Ultimately the choice of which options you choose will be dictated by your strategy, time available and the sophistication you wish to apply to your own trading. At their most basic level, binary options are a simple and low risk way to trade market direction. And with an on exchange broker such as Nadex, you will be trading in a safe, secure and transparent environment.
But in my humble opinion binary options can offer so much more.Before moving on to look at the bid and offer in more detail, along with how we trade these options, their associated risk and reward ratios and how they are priced, let me introduce one further notion. When considering an options ladder we are also viewing the market’s opinion of the probability of strike prices being achieved higher or lower in the chain.
This may sound obvious, but it can be useful when considering risk and return, as well as setting take profit targets of which more later.Here is an example using the ladder from Fig 4.13, and taking the mid point probabilities, as we are going to cover the bid and offer relationship in the next section. If we take the six strike prices from >1843 and below and their associated mid point probabilities, these are as follows:
> 1843 – 45.00
> 1840 – 52.50
> 1837 – 61.25
> 1834 – 73.00
> 1831 – 81.00
> 1828 – 85.75
Assume we want some idea of how the probabilities on our options are likely to change if the underlying market were to move higher by 3 index points. In other words move to the next strike price level. Let’s assume the underlying future is trading around the 1840 strike price level, and we want to have some idea of what would happen if the index moved to 1843 in a relatively short period. As always time will have a major influence on the probabilities being quoted. What we are considering now is a ‘what if’ scenario of the market possibly moving higher to 1843 in the short term. In simple terms the ladder ‘steps up’ one level as follows:
> 1843 – moves from 45.00 to 52.50 = 07.50
> 1840 – moves from 52.50 to 61.25 = 08.75
> 1837 – moves from 61.25 to 73.00 = 11.75
> 1834 – moves from 73.00 to 81.00 = 08.00
> 1831 – moves from 81.00 to 85.75 = 04.75
What we are considering now is the comparative shift in probabilities if the index moves a full strike price in the short term. It is the market’s view of the future probability at this price level – in the short term. We can use this information in one of two ways. First it gives us a perspective on which options may offer the best returns, should the market move this far. In this example we can see the most significant shift in probabilities is on the 1837 strike option, with the least significant move on the 1831 strike option. This is as we would expect.