By Darrell Martin
Four factors influence the price of a binary option. The following is practical information that will help you understand how a binary is priced. These four factors are all influential, important and somewhat intertwined in the price of a binary option.
The four factors that influence a binary option’s price are:
- Time until expiration
- Strike price proximity to underlying price
- Implied volatility
- Other traders
Whether you trade during the day or night, there is usually an instrument with an expiration time approaching. You have many different duration choices with binary options; some that expire in a week down to 5 minutes and many times between. It’s up to you which binary duration and strike is the best fit given your underlying market view.
The binary price reflects the probability of the binary expiring in the money (ITM). Time value will decay in the binary pricing as time goes for the binary strikes which are out of the money (OTM). Here the time value decreases as there is less time for the market to move. A binary that is not in the money with time running out, results in a higher probability expiring out of the money.
Conversely, the binary pricing increases in value as the time gets closer to expiration for binary strikes that are ITM. With time getting close to expiration, the binary is already ITM resulting in a higher probability of expiring ITM for the settlement payout.
The farther away the binary is from expiration, the slower the price moves. Therefore, a binary with a weekly expiration moves very slowly making some traders wonder why anyone would want to wait four days to make what they can make in 40 minutes!
If the underlying market is trading at the same price as the binary, regardless of time passing, the price will be around 50. This does not mean that the price will remain at $50 but as long as the underlying market stays at that strike price, the binary price will stay around 50. As the market moves to that strike price, whatever contract is available will become at the money (ATM) and be priced around $50. Knowing this fact could help you in targeting a price on the chart.
When you look at the strike prices as they appear on the binary price ladder, you may think that you can choose your own price for your trade and you would be correct. However, you will have a better chance of having your order filled if you choose a price that actually exists on the price ladder.
Choose the best strike price by knowing the expectation of movement, making sure it is a realistic price for the time frame and selecting the correct expiration time.
Understanding the benefits of out of the money (OTM), at the money (ATM) and in the money (ITM) can help you in trading binary options. There are explanations that are more detailed available, but here is a very basic description of each one:
OTM has a lower risk with less than $50 on either side.
ATM is right at the market. This strike price is in proximity to the underlying price and will remain consistent with the market price.
ITM has a higher risk. If buying, the strike is already greater than where the market is trading. If selling, the strike is already at or less than where the market is selling.
Implied volatility is expected movement built into the price of a binary option. It can be affected by news and other events that cause movement in the markets. Being aware of such happenings can protect your trades. There are strategies that can be used for news events.
Other traders can influence the price of the binary option. There are market makers that provide liquidity and keep the market moving by giving quotes on both the buy and sell sides of trades. It is important to know that when you trade with an exchange, they are not on the other side of your trade. Other traders and market makers are on the other side of your trade. The exchange is only facilitating the transaction between a buyer and a seller.
