BINARY OPTION’S PRICE AND ITS REFLECTION

BINARY OPTION’S PRICE AND ITS REFLECTION
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Who is an easy question to answer: it’s the market participants themselves. The buyers and sellers decide the price at any given moment based on their collective opinion.

Now let’s look at how those buyers and sellers determine price. Before a binary option expires at either $100 or zero, its price moves up and down as long as the underlying market moves (though not in strict correlation). During that period, its trading price may fall anywhere between zero and $100.

The price of the binary reflects the probability that it will expire “in the money,” meaning above the strike price. So in the case of our euro example: EUR/USD > 1.1300 (7pm). The price of the binary option will go up and down based on whether it looks likely to expire above 1.1300 at 7pm.

Can you see how all the factors that play into that probability will also affect the price? If it is hours from 7pm and the market keeps bouncing above and below 1.1300, it’s hard to say what is likely to happen. Anything could happen before 7pm.

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The price will reflect that 50/50 probability by being about $50 at that time. The best bid and offer may be something like 48-52. Let’s continue with the same example: EUR/USD > 1.1300 (7pm).

Imagine it is 6pm (ET), i.e. one hour before expiration, and that the underlying spot EUR/ USD FX rate is standing at 1.1290. If it is at 1.1290 an hour from now, at 7pm, the binary option will expire with a value of zero and you will lose whatever you paid (but not more).

Let’s think about the probabilities of where it can go in the final hour before expiration. Markets can go in one of three directions: up, down or sideways. Right now, it’s below 1.1300. So the chance of it staying below 1.1300 are good compared to other possibilities. It doesn’t have to do anything to get there. It’s already there.

If the market stays there, the binary option will expire at zero. If it goes down, the binary will also expire at zero. Then there’s the third possibility: that the EUR/USD rate will go up in the next hour and be above 1.1300 at 7pm. That’s one of three possible outcomes. And actually, it’s a little less than a one-third possibility, since the market could go up but then still be below 1.1300 at 7pm. In other words, it is reasonable to believe it is more likely that the binary will settle at zero than that it will settle at $100.

The pricing of the binary option will reflect the probability of the EUR/USD rate being above 1.1300 at 7pm. Since right now that is less probable than the market staying at or below 1.1300, the binary option might trade on Nadex at around $30.

This price would imply that Nadex participants (those actively buying and selling that binary option) believe there is only a 30% chance that the binary option will settle at $100.

Remember that Nadex doesn’t influence the pricing or participate in trading. The value judgments are made by the buyers and sellers. We’re just the exchange, making sure everything is done fairly and accurately.

So with the underlying market at 1.1290 at 6pm (ET), the market is likely to think there’s a smaller chance (about 30%) of the rate being above 1.1300 in another hour, and greater chance (about 70%) that it will be the same or lower than it is now.

So at 6pm, the answer to “will the EUR/USD exchange rate be above 1.1300 at 7pm?” seems more likely to be “no” than “yes.” The pricing will roughly correspond to that and be about $30 to buy the option and $70 to sell it.

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