By Darrell Martin
A binary contract is a True/False, Yes/No statement. For example, the contract states that at 1:20 pm today, the Wall St 30 (Jun) will be >20648. If you agree with the statement, buy. If you believe the statement will be false, sell. The contract will be worth either zero or $100 at settlement. It is as simple as that to understand, yet there are people who will say that binary options are not fair. They are a scam and they don’t work. How can a bought binary lose if the market is uptrending? Let’s break down the binary to better understand how Nadex binary options work.
Nadex binary options and spreads follow the market using an indicative price. The indicative price is the calculated level of the underlying market. Nadex has a definite process for calculating those levels, which also determines expiration values. See Nadex Indicative Index Value.
If you are new to trading binaries, you may think that if the market is moving up, you need to buy. You look at the Nadex strike ladder, select a contract, open a ticket and realize you have to risk $78 to make $22. That doesn’t sound good to you, so you don’t choose that contract and instead pick another strike. When you click to open that ticket, you see that you are only risking $13 to make $87. This choice makes sense because the market is going up; therefore, you buy, because that is what you learned from a webinar.
However, to your utter dismay, even though the market is going up, your option’s price is going down. As time runs out, the binary settles at zero and you rant that binaries down work! You ought because the market was uptrending, but the price went down to zero and you lost! Why didn’t the price go up?
The Importance of Time The simplicity of binaries can make it seem that all you have to know is the direction of the market and then make a yes or no decision. It isn’t just the direction of the market. You have to choose the right binary strike.
Sometimes you may buy a strike and watch it go up, but the strike you bought is so far out of the money (away from where the market is trading) that it has little probability that the market will reach that predetermined level before expiration. It may have so far to go up in order to be a correct statement that as it gets closer to expiration, the less chance and the lower probability it will get to 100.
It may have an even slimmer chance of getting up to the strike price, where it would be worth $50. Therefore, the price and value of the contract is pushing towards zero. This is time decay. The market is going in your direction, which in this case is up. However, since it is close to expiration, the probability is low, and then the value of the binary is going down.
A very important step is determining the market condition. Is it uptrending, downtrending or range bound? In addition, you have to be aware of the importance of time and the probability that the market will make it to your chosen strike price before expiration.
Note: Exchange fees not included in calculations.