By Darrell Martin
The underlying market affects the pricing of binary options. Binary options are options, so time, volatility and the underlying market price have bearing on the pricing in many of the same ways as regular options. However, the price of the binary trades in a range between 0 and 100.
When the underlying market is trading at or near the binary strike, the binary should be priced around 50. At expiration, the binary will be worth $100, but can only go to the buyer or seller- the trader who is correct. The buyer believes that the underlying market price will be greater than the binary strike at expiration, while the seller believes the underlying market price will be equal to or less than the binary strike at expiration.
Neither the buyer nor the seller has the advantage when the underlying market is trading at the strike. Therefore, the fair value price should be half of $100 or around 50. If the underlying market moves higher, the price of the binary will reflect that by increasing in value. The binary price will be greater than 50. The closer the price gets to 100, the happier you are if you have bought the binary option.
If the underlying price has moved and is trading below the binary strike, the binary will be priced less than 50. The farther the underlying moves below the strike, the closer the binary price will be to zero. This is what you want to happen if you have sold the binary option.
It is important to realize what time can do to your trade. If you have bought a binary that has spiked up in price, but still has several hours until expiration, you would be wise to exit early. You may give up a few dollars, but if you hold until expiration, you risk losing it all.
Volatility can also impact your trade. You may see the price up near 100, only to drop down to 25 and then bounce back up again. Be aware of events influencing the markets and plan your trades accordingly. Protect your profits and cut your losses as necessary.
Knowing how the underlying market affects the pricing of binary options can help you as you learn to trade binary options.