Binary fair value

July 14, 2014 10:34 AM

One of the main benefits of binary options is that the price of binaries offers insight into what the markets believe the odds are for a particular action. With outright futures or options there are a myriad of fundamental and technical factors to look at and price can move anywhere—up, down or sideways and then quickly change direction—typically without any notice. 

Binary option contracts are simple yes/no questions that allow the end user to take a position in a particular market because he thinks price is moving in a certain direction, or because he thinks a certain upcoming event will cause the market to move in a certain direction, in a specified timeframe. 

Binaries are much simpler than futures or traditional options because every contract will settle at either zero or $100. The price on binaries, like every other market, will fluctuate.

In the futures market, fair value is the equilibrium price for a futures contract. It refers to the relationship between the futures contract on a market index and the actual value of the index. If the futures are above fair value then traders are betting the market index will go higher, the opposite is true if futures are below fair value.

For example, let’s say crude is trading at $103 on a Monday with a possible 40 bid/42 offer. This pricing would indicate that market players think there is roughly a 41% chance that crude is headed higher. This information goes a long way in allowing the trader to eliminate a lot of superfluous noise factors and focus on the specific yes/no question. Most of the factors that move the market prior to the Wednesday inventory report will be relatively minor and may be regarded as simply noise.

If a crude oil inventory report is coming out on Wednesday that you think will affect crude by causing prices to go up to $105 or more by the end of the trading week, you would buy a binary option that reflects that. If price goes up to $105, when the contract expires your contract is worth $100.

However, if you were wrong about price direction then the contract expires at $0.

Perhaps the greatest value in binaries is that you can pick a specific price. You may think that a particular price on a market is high or low, but your opinion of that really has nothing to do with the overall opinion of the market itself. Perhaps you think that the Wednesday inventory report will be bullish and the market will move up. Perhaps you feel that the current news cycle is painting a rosy scenario of the geopolitical risk in the Middle East due to one positive story. That story may have pushed the crude market lower in the last 24 hours, but you expect it will move back up by the end of the week, and if you see more traders purchasing binary options that shows they expect the market to end higher by the end of the week, then that market sentiment will confirm your own view.

No trader is right all the time so it’s important to maximize your gains when you are correct. Also, not every winning trade is a great trade and not every losing trade is a bad trade. The key is to get the most out of your winners and to get smaller losers because you will inevitably have both. Having an understanding of fair value will help, and binary options make that simple.


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