Binary Option Pricing The 4 Factors that Impact Your Trading

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Binary Option Pricing

Are you a regular Binary Option trader? How profitable is your trading? These are questions which no doubt go to the core of any dedicated trader.

What we at the trading club have noticed is that traders who are trading options these days are not necessarily using strategies that take advantage of Binary Option Pricing. More particularly, they do not take a view on the various components of this price.

Why simply trade the trend on the EUR/GBP when you can take advantage of underlying movements in the volatility, time to expiry and strike to shape your strategy?

Of course, Binary Options pricing can be quite a complicated procedure. Indeed, most online resources will point people to explanations which involve advanced derivative mathematics like the black Scholes model. These are mainly used by OTC traders at global investment banks.

This, however, should not deter you. If you can understand the main components of a Binary Options price, then you are best positioned to make a profit from the movements in these variables.

Short Overview of Binary Options

As many will now know, a binary is a unique type of option that has only two payoffs. These are either 0 or 100 on most platforms. Of course, the pay-out can technically be a number other than 100 but we are keeping it at this level for simplicity sake.

The trader enters the option and will get the pay-out if the option expires in the money and will lose the entire initial investment if it expires out of the money. Whether the current price is above or below the strike at expiry and how it impacts “money-ness” is a function of whether the option was a call or put option.

You can read more about what Binary Options are if you would like to understand these concepts more concretely before continuing.

Components of a Binary Option Price

What is important to note about Binary Options is that they are merely a variant of traditional American options with a Binary Payoff. As such, they are impacted by the same components and inputs as traditional American options.

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If you are vaguely familiar with Option pricing then you will know that it is normally determined by a function called the Black Scholes model. As complicated as it may look, one merely needs to understand that the function has a number of inputs. The main inputs of this function are no doubt the current price, the volatility in the underlying price and the in the time to expiry.

Hence, if either of these inputs changes, it will most likely have an impact on Binary Option pricing. As such, this is the opportunity for the astute trader to make extensive returns and improve their performance.

How Likely is a Win?

A great deal of binary option pricing and trading comes down to probability theory. How likely is it that the option will expire in the money and hence pay-out? This probability will impact on the price someone is willing to pay for a Binary Option in the market. The more certain the traders are that the option will end in money, the closer there are willing to pay to the 100 pay-out number.

All of the components that we have mentioned above will impact on the probability that the option will end in the money at expiry.

Using an actual example, assume that there is a Binary Option which has a pay-out of 100 with an expiry in the money. The current price of the option is at 30. If the option expires in the money, the pay-out will be 70. This implies that the chance of the option expiring in the money is only 30%.

Current Price (S)

This is probably one of the factors that most greatly impacts binary option pricing. This is because where the current price is will determine whether the option has expired in-the-money and whether the trader has won.

Therefore, it also impacts on the probability of an expiry in-the-money if there is still time till expiry. For example, taking a look at a CALL option. If the current price is above the strike then the price of the option is likely to be above 50 to reflect the increased probability that it will expire in-the-money.

Similarly, on the flip side if the price of the underlying is considerably below the strike, there is a reduced probability that it will expire in the money and hence a lower option price to reflect this.

If we wanted to take a look at an example that involved actual option pricing, let’s say that you wanted to enter a GPB/JPY binary CALL option with expiry in 2 hours. The strike price of the option (K) is at 140.50 and the current GBP/JPY level is at 142. This implies that the option is more likely than not to expire in the money and hence it will demand a price above 50.

This does assume that the other two components that we will mention below are held constant.

Volatility (σ)

In traditional option pricing, volatility (σ) drives the price as well. In fact, in big Investment banks, the option traders are termed the “volatility traders” and these traders only take views on the movement of the volatility and not necessarily the price.

Indeed, volatility is quite a complex discipline to understand. There are different classifications such as implied volatility, realised volatility, and volatility on volatility. However, for the average Binary Options trader, all you have to understand is that the volatility is a measure of how quickly and regularly the underlying asset moves in price.

For the trader, this is an important component. It means that the option may quickly swing into the money before expiry even if it is currently below the strike price. Similarly, it could also impact on the price of an option that is in-the-money. This is because there is also a chance that it could move out of the money and lose.

If you were a trader who wanted to trade the asset’s volatility, how would you go about it? You could make a relative value trade on the volatility implied by the option price and that which is currently prevailing in the market.

For example, let us assume that there is an asset which usually moves about 18 points in a day. However, currently the market is relatively quiet and its maximum movement over the past few hours was only 8 points. This means that if the option is in the money, you can enter the Binary Option at a relative bargain as it is unlikely to swing out-of-the money and result in a losing trade.

Time to Expiry (T-t)

We are all aware of the old adage that “time is money”. In option land, that also holds true and in many cases time to expiry (T-t) is termed the “time value” of the option.

Coming back to probability calculation that the trader makes, the time to expiry adds uncertainty to the calculation. This is indeed true for many other things in life. The more time that we have the more certain we are of reaching an end goal. This could be completing assignment or reaching a destination on a trip.

When someone is pricing a binary option, the time the option has to expire will impact on their mental calculation of whether they will win the trade. For example, if the binary option is currently out of the money and is 30 seconds to expiry, you can be fairly certain that it will expire and you will lose the trade.

However, if there was still 12 hours to go to expiry then there is still enough time for the option to move into the money before expiry.

How might the Binary Option trader enter a trade based on the time to expire? Given the unique nature of a Binary Option payoff, a chance for large payoffs is possible when the option is near expiry. For example, if the price of the option is quite near the strike price and near expiry, there is the chance of a large swing in the price as it approaches the “all or nothing” payoff.

Taking a look at the above example of the GBP/JPY, if the strike is at 140.50 and the current price is equal to the strike, there is an almost 50% chance that it will either payoff 0 or 100 in a very short period of time. Hence, a trader who strategically enters the option near expiry can make a rather impressive return on the trade.

A Comprehensive Approach

Of course, the astute trader will not merely look at only one component and trade solely based on that. Each of these factors have an impact on binary option pricing to varying degrees dependent on the underlying asset. One can think of them as three legs to a chair. Each as is important as the other and a trader needs to make a careful analysis of the relative impact of each on the option price.

Moreover, the really successful trader will combine use these factors in a comprehensive trading strategy. This should include a strategy that includes technical analysis with binary option signals and fundamental analysis of Economic conditions.

Is Binary Options Trading Safe?

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The general answer is yes when you consider the following points:

  1. It is a regulated financial instrument in the EU and many parts of the world.
  2. The risks are known and, to some extent, predictable since it’s a zero-sum forecast.
  3. There are demo trials before you put in an investment.
  4. Major binary options offer reliable customer support.
  5. The terms on deposits and withdrawals are spelled out clearly.

Binary options have attracted traders of all experience levels—from beginners to professionals—who are in a quest for diversifying their investments. This type of trading has grown to a respected and credible practice over the years. Despite this, one of the concerns of many, especially when it comes to where they put their money, is the question: is binary options trading safe?

In this article, we’ll be shedding light on the answer to this often-asked question about binary options trading to help you make an informed decision. We’ll also provide some guidelines for choosing the best platform for binary options trading and discuss factors that impact trading risk.

Is Binary Options Trading Safe Table of Contents

Binary options trading: A regulated financial instrument

After its exponential growth since 2008 and its reclassification into a financial instrument in 2020, binary options trading gained mass credibility. During that time, it experienced a surge in people searching for the term “binary options” in Google Trends, which surpassed the frequency of another related famous term “forex trading” according to Futures Mag. One of the reasons behind this increase in interest is the regulations established for this financial vehicle.

Binary options trading is a regulated product by EU jurisdictions such as CySec (Cyprus Securities and Exchange Commission) and MFSA (Malta Financial Services Authority), among others. Furthermore, regulators continue to tighten directives and mandatories. Financial Times reports on the recent actions taken by FCA (Financial Conduct Authority) to protect consumers by examining firms that may be offering binary options illegally.

Hence, if your definition of safety in the question “Is binary options trading safe?” is whether it’s regulated and legal, then yes, it is; as long as you choose the right binary options brokers (which we’ll get into later). If your concern is whether it’s risk-free, then, of course, any trading—not just binary options—entails risk. Every venture, business, and investment accompanies a calculated risk as there’s no guarantee of solid future performance.

Acknowledging risks and trading responsibly are some of the primary ways to safely approach trading. With that in mind, let’s delve deeper into answering whether binary options trading is safe in terms of its methods, platforms, and trading mechanics.

Is Binary Options Trading Safe?

Binary options are generally considered a safe investment. However, as with all money instruments, it pays to do your research to guarantee you are dealing with a legitimate provider. Here are the main reasons why this trading avenue can be one of the safest options for you.

Simple, Easy-to-understand Premise

Probably one of the most desired advantages of binary options trading that attracts many traders is its simplicity. It has a simple premise that gives you only two (thus, the term “binary”) options and outcomes. Based on your informed guess as per various factors and patterns, you’ll choose and predict the asset’s movement if it will be true at a specific point in time. It’s a straightforward “yes or no” proposition, where you’ll get a fixed percentage of your investment if you’re successful or none if you’re unsuccessful. That’s why it’s also called an asset-or-nothing option.

With binary options, traders don’t have to purchase or own an asset. Assets may be commodities (such as crude oil, silver, and gold), currencies, and stock indices, among others. With the unprecedented growth of cryptocurrencies and over 17 million Bitcoins in circulation today, some brokers also allow cryptocurrency trading. IQ Option, for instance, supports not only Bitcoin but also Ethereum, Ripple, and Litecoin.

Getting started is also easy. Traders only have to choose a broker, register an account, and immediately start trading. While being knowledgeable about this type of trade is still vital, you’re not required to have as much extensive knowledge as other types such as forex trading. With that, even beginners can work their way up and choose among different types of binary options.

There’s an option for everyone where they’re comfortable to make investments. They can opt for a simple call and put options or double no-touch binary options and vanilla options or exotic options, among others. In this way, a trader understands, based on level of knowledge and skills, how it works and avoids trading blindly. Meanwhile, more seasoned traders have the opportunity to choose more complex options where they get higher returns with bigger risks and reward paydays.

Known and Limited risk

When you trade binary options, you’re aware right up front how much you are risking and how much your potential profit will be on its outcome. You’re only risking the amount you choose, no matter how large or small it is. Additionally, there’s no risk of leverage, which means you won’t lose more than the amount you risked in the trade, unlike some other types. This way, you’re prepared for incurring potential losses as long as you choose to invest an amount that’s within your means. This prevents you from losing more than what you can afford.

It’s also an affordable way to trade online as you’re not required to trade large amounts. Depending on your chosen broker, you can trade from as low as $1. Some even give you a demo account that you can play around with to help you practice and get the hang of binary options trading before investing your real money. Our top binary options brokers let you trade from $5 to $10 as a minimum amount. It’s safe in a way that you’re not forced to lose any amount right from the get-go.

High and fast returns

When you invest, one of your goals is to get high returns. Due to binary options’ higher risk nature, its returns are also typically higher. It yields a return that amounts to an average of around 60-90%, depending on your broker. Its fast turnover rate also ensures a quick payout. Varying from different assets, the expiry times can range from a few minutes or less than an hour (sometimes even seconds) up to a few weeks. If you opt for daily binary options traders, you can trade multiple times a day for a potentially higher profit.

This gives you access to a variety of assets that are available to trade, which is an excellent way to diversify risks and control the amount of risk at a given time. If you’re successful, you can immediately see the amount added to your account. Depending on your chosen platform, you can also instantly withdraw your money. Meanwhile, if you’re unsuccessful, some brokers offer a small return based on how much you invested. For instance, you won’t lose 100% of your investment, but you’ll still get around 5-15% of it back.

Choosing A Binary Options Broker

Is binary options trading safe? As mentioned in the previous sections, it is safe as long as you’re a responsible trader. After all, there’s a difference between taking risks, which is necessary for any venture, and being risky, which is blindly being too ambitious in your trades. One of the most important and fundamental ways to reduce risks is choosing the right binary options brokers. Since it’s the platform where you’ll be doing your trading, you must check the following:

  1. Regulation. Your broker must, first and foremost, be licensed and regulated. This ensures it adheres to the guidelines of the regulatory authority or financial regulator. Since regulators pay close attention to their business practices and ensure fairness, you can assure the broker is trustworthy and transparent.
  2. Trading software. Ease of use, speed of execution, and a well-designed interface are essential as it plays a vital role in your trading endeavors. Mobile trading is also worth considering so you can trade anywhere, anytime.
  3. Demo/trial account. This is an important feature to test the software and get acquainted with it, especially for novice traders. Also, ensure it’s using real live market data.
  4. Customer support. A broker with reliable customer support that’s available in various languages and support channels, such as live chat, ticket messages, phone, and email, is important as it also shows their credibility. Some broker platforms may also offer features of customer support software for added convenience.
  5. Deposits and withdrawals. Checking a broker whose minimum deposit and withdrawal amounts you are comfortable with is crucial. Also, check if they offer convenient processes and quick timeframes, especially when it comes to the withdrawal process.

A good example of a binary options broker that includes the factors mentioned is IQ Option. It’s licensed and regulated by CySec, which guarantees its compliance with relevant regulations and jurisdictions. It has a top-notch online trading platform that offers both ease-of-use and functionality to veterans and novice traders. Newcomers can make use of a broad range of educational materials such as tutorials, webinars, e-books, and FAQ sections about the platform and binary options trading.

How Does Implied Volatility Impact Options Pricing?

Options are derivative contracts that give the buyer the right, but not the obligation, to buy or sell the underlying asset at a mutually agreeable price on or before a specified future date. Trading these instruments can be very beneficial for traders. First, there is the security of limited risk and the advantage of leverage. Secondly, options provide protection for an investor’s portfolio during times of market volatility.

The most important thing an investor needs to understand is how options are priced and some of the factors that affect them including implied volatility. Option pricing is the amount per share at which an option is traded. Although the option holder is not obligated to exercise the option, the seller must buy or sell the underlying instrument if the option is exercised.

Learn more about options, and how volatility and implied volatility work in this market.

Key Takeaways

  • Option pricing, the amount per share at which an option is traded, is affected by a number of factors including implied volatility.
  • Implied volatility is the real-time estimation of an asset’s price as it trades.
  • When options markets experience a downtrend, implied volatility generally increases.
  • Implied volatility falls when the options market shows an upward trend.
  • Higher implied volatility means a greater option price movement can be expected.

Options

Options are financial derivatives that represent a contract by a selling party—or the option writer—to a buying party—or the option holder. An option gives the holder the ability to buy or sell a financial asset with a call or put option respectively. This is done at an agreed price on a specified date or during a specified time period. Holders of call options seek to profit from an increase in the price of the underlying asset, while holders of put options generate profits from a price decline.

Options are versatile and can be used in a multitude of ways. While some traders use options purely for speculative purposes, other investors, such as those in hedge funds, often utilize options to limit risks attached to holding assets.

Options Pricing

An option’s price, also referred to as the premium, is priced per share The seller is paid the premium, giving the buyer the right granted by the option. The buyer pays the seller the premium so he has the option to either exercise the option or allow it to expire worthless. The buyer still pays the premium even if the option is not exercised, so the seller gets to keep the premium either way.

Consider this simple example. A buyer might pay a seller for the right to purchase 100 shares of Company X’s stock at a strike price of $60 on or before May 19. If the position becomes profitable, the buyer will decide to exercise the option. If, on the other hand, it does not become profitable, the buyer will let the option expire, and the seller gets to keep the premium.

There are two facets to the option premium: The option’s intrinsic value and time value. The intrinsic value is the difference between the underlying asset’s price and the strike price. The latter is the in-the-money portion of the option’s premium. The intrinsic value of a call option is equal to the underlying price minus the strike price. A put option’s intrinsic value, on the other hand, is the strike price minus the underlying price. The time value, though, is the part of the premium attributable to the time left until the option contract expires. The time value is equal to the premium minus its intrinsic value.

There are a number of factors that affect options pricing including volatility, which we’ll look at below.

Other factors that affect options pricing include the underlying price, strike price, time until expiration, interest rates, and dividends.

Implied Volatility

Volatility, in relation to the options market, refers to fluctuation in the market price of the underlying asset. It is a metric for the speed and amount of movement for underlying asset prices. Cognizance of volatility allows investors to better comprehend why option prices behave in certain ways.

Two common types of volatility affect option prices. Implied volatility is a concept specific to options and is a prediction made by market participants of the degree to which underlying securities move in the future. Implied volatility is essentially the real-time estimation of an asset’s price as it trades. This provides the predicted volatility of an option’s underlying asset over the entire lifespan of the option, using formulas that measure option market expectations.

When options markets experience a downtrend, implied volatility generally increases. Conversely, market uptrends usually cause implied volatility to fall. Higher implied volatility indicates that greater option price movement is expected in the future.

Another form of volatility that affect options is historic volatility, also known as statistical volatility. This measures the speed at which underlying asset prices change over a given time period. Historical volatility is often calculated annually, but because it constantly changes, it can also be calculated daily and for shorter time frames. It is important for investors to know the time period for which an option’s historical volatility is calculated. Generally, a higher historical volatility percentage translates to a higher option value.

Option Skew

Another dynamic to pricing options, particularly relevant in more volatile markets, is option skew. The concept of option skew is somewhat complicated, but the essential idea behind it is that options with varied strike prices and expiration dates trade at different implied volatilities—the amount of volatility is uniform. Rather, levels of higher volatility are skewed toward occurring more often at certain strike prices or expiration dates.

Every option has an associated volatility risk, and volatility risk profiles can vary dramatically between options. Traders sometimes balance the risk of volatility by hedging one option with another.

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