Where will the markets go? Many traders will look to charts for the answer and technicians believe that price action is the best predictor of future direction. But the problem with these assumptions is that they do not always hold true. If price were that good of an indicator, why are there surges, spikes and crashes? Basically, why is there volatility? Evidently, price is not a predictor of surprise. The challenge facing traders is, therefore, not only choosing direction, but choosing the direction that would benefit from surprises.
At the open of the week for global markets, traders have the challenge of balancing expectations about the coming week. Unless over the weekend there has been breaking news, the week starts with the maximum amount of chatter filling the internet. Whether it is rumors of a China slowdown, Middle East tensions or global growth projections, the “information set” available for traders on Monday morning is incomplete. A classic example was the Sept. 29 cover of The Economist. Its headline stated: “Be Afraid” as the Greek sovereign debt crisis was causing extreme anxiety. Yet, what did the DAX index do in the weeks that followed? It reversed and rallied. The headlines were a classic fade.
Evidently, traders simply can’t wait for extreme headlines to anticipate direction. Also, anticipating or expecting surprise seems to be an oxymoron. Yet, technically, it can be done with binary options. Binary options provide a fixed payout, $100 per unit for example, if the trader chooses the strike price correctly. The weekly binary options (offered at Nadex) therefore can be treated as expected probability streams for price direction. If on Monday morning the EUR/USD spot is at X and an option strike has an ask price of $25, it means that the expected probability of the EUR/USD reaching that price is being set at 25%. Another way to look at it is that 75% of the notional value in that strike expects the market not to reach that price. An examination of Nadex option bid-ask prices in the $20-$30 range from August 2011 to Feb 2012 provided interesting results. The percentage of winning trades — those that settled at $100 — was considerably lower than the $20 to $30 price would have indicated: AUD/USD 15.3%, EUR/JPY 13%, EUR/USD 7.4%, GBP/JPY 17.6%, USD/CAD 2.9% and USD/JPY 12.1%.
By looking at the strike prices of binary options, traders identify alternative support and resistance. Traditional support and resistance is found by locating previous highs and lows and using other technical indicators. In contrast, sentiment support and resistance, derived from binary options, are based on the opinion of traders. Traditional support and resistance levels show where the price has been, sentiment support and resistance levels show where the price is expected to go, or rather not go.
“Narrowing our target” shows a weekly euro chart on the Monday, March 5 open. We placed — inside the traditional support and resistance levels — sentiment support and resistance derived from the weekly Nadex EUR/USD binary option bid and ask prices. The resistance sentiment level shown is 20%, indicating an 80% expectation (but probably higher based on our study referenced above) that the price will not reach that level by the end of the week. The sentiment support level shown is roughly 80%, meaning a 20% expectation (probably lower) that price will reach that target at the end of the week. This balance is called “sentiment polarity.” A strike price of $20 on the ask would be balanced by a strike price of $80 on the bid. A trader can choose a range that matches his risk preferences.
On the morning of March 5, sentiment support and resistance using the 80/20 sentiment polarity ratio showed that the spot price was much closer to the sentiment resistance level than to the sentiment support level. This showed a bearish sentiment bias. It also was an indication that a short position was a lower risk option, as you could place a tighter stop based on support and resistance levels. The EUR/USD sell off that subsequently occurred confirmed that the bearish crowd was right.
Using weekly binary options to find sentiment polarity can be an effective tool to improve your trading. Every market is made up of traders, so any clue you can gain regarding the sentiment of other traders can only help your analysis.
Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of “Fear and Greed Trader” at Agora Financial and can be reached at email@example.com.