One of the greatest benefits of binary options is that your risk is fixed at the time the trade is initiated: the binary contract will either settle at zero or 100 at expiration, but that doesn’t mean you have to wait until expiration to exit the trade. In quiet markets, binaries still offer trading opportunities as you can trade the range and take advantage of small price movement between support and resistance.
Remember at the expiration, the binary is worth $100 per contract so if the binary expiration value is above the strike by only a tick or greater, the binary buyer receives the $100; if the binary expiration value is at or below the strike the seller receives the payout.
Last week we mentioned how you can use binaries to hedge an underlying position going into an economic report. You also can extract value around those reports on reversion to the mean type trades. Often a market will overreact to the initial announcement and then return to an equilibrium level. There are a lot of opportunities in a range trade before a market picks a direction.
This brings to mind another benefit of binaries. They serve as a proxy for sentiment on the underlying market. Market sentiment refers to the overall mood that investors are feeling towards a particular underlying asset class or the overall financial market. The investor feeling or mood is often apparent and is typically translated into action through the movement in prices and trading volume.
Market sentiment generally can be classified into bearish or bullish markets. We know that prices in the market fluctuate because of the way market participants anticipate where prices will go. It’s all about learning how to react in response to what the market is doing.
For those traders struggling to determine where short-term market sentiment is leaning, monitoring the North American Derivatives Exchange (Nadex) binaries on a particular underlying market is a good indicator. It can be a valuable tool in your tool box when analyzing such underlyings as the CME® E-mini S&P® 500 Index futures or a particular currency pair.
The way binaries are structured provides a specific percentage for the chances of a specific move. The quoted price of the Nadex binary is the market’s view of the binary buyer’s probability that the particular underlying market will finish above the particular strike. The binary seller’s probability is actually the remainder or difference from 100 (100 payout – binary price = seller’s probability).
In fact, one of the first uses of binary options was as a “prediction tool” for the Iowa Election Market. The concept was that students would conduct more extensive research to make better decisions with real money on the line. In a 2008 paper published in the International Journal of Forecasting, Fellows of the Tippie College of Business at the University of Iowa Joyce E. Berg, Forrest D. Nelson and Thomas A. Rietz wrote “We compare market predictions to 964 polls over the five Presidential elections since 1988. The market is closer to the eventual outcome 74% of the time.
Further, the market significantly outperforms the polls in every election when forecasting more than 100 days in advance.”
The bottom line is numerous traders putting real money on the line is a great indicator on sentiment and can help in your analysis of markets.
In the coming weeks we will provide specific examples, as well as cover how to use binaries to take outright positions and to hedge risk.
NOTE: CME® is a registered mark of the Chicago Mercantile Exchange. S&P® 500 is a registered mark of the McGraw-Hill Companies Inc. Nadex is not affiliated with the Chicago Mercantile Exchange or the McGraw-Hill Companies and neither the Chicago Mercantile Exchange, the McGraw-Hill Companies, nor its affiliates, sponsor or endorse Nadex or its products in any way. In particular, the Nadex US 500 Contracts are not sponsored, endorsed, sold or promoted by CME or the McGraw-Hill Companies.