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Using Binary Options for FX Trading

Accendo Markets
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Thales of Miletus was a 5th century B.C.E. Greek philosopher to whom credit is given for writing the first ever options contract. Aristotle recounted that early one spring Thales reserved all the olive presses in Miletus at a discount. When harvest time came and the olives needed to be pressed, he leased the presses out at a much higher price. When you stop and think about it, he was quite clever. The reservation price had to be high enough to give the press owners an ‘up front’ profit as good as they expected to earn at harvest time. Hence, Thales’ offer included both the intrinsic value of renting each press and also the time value for keeping the presses on reserve until the harvest. Thales’ contract transferred the risk of the unpredictable future demand from the olive press owners to himself, while never having to purchase a single olive press. He merely held a contract! According to Aristotle’s recounting, there was a bumper crop that year and Thales profited very well. Imagine! The Greeks inventing options contracts. How apropos!

The evolution of regulated options trading had its origins after the crash of 1929 with the establishment of the US Securities and Exchange Commission and the licensing of CBOE for options trading. It reached its modern form in the late 1960s and was further legitimized by the Black-Scholes thesis on derivative pricing and the creation of the Options Clearing Corporation in 1973. Today, Option Contacts of many types and exotic styles cover the entire spectrum of underlying securities. Now, thanks to very high speed digital communications, options contracts have reached the next stage in their evolution: Binary Options.
Binary Options are very short term. Expirations may be as short as 20 minutes or as long as one week.

It’s a bit complicated to understand, but once you have a grasp of how it works, it’s quite interesting and potentially very useful.

The very basic premise is that the outcome is all or nothing. The price of a binary is always between $0 and $100. The reason why will be of interest to the options enthusiast but first it’s important to understand ‘Floor and Ceiling Prices’ and ‘expiration value’. The calculated expiration value may be considered the equivalent of a plain vanilla option’s ‘strike price’. Floor and ceiling prices are determined by the market. The spread between the floor and ceiling is always 100 units, pips, tics, centimes, etc.

For example, the floor and ceiling prices of a EURUSD contract are $1.0579-$1.0679. The calculated expiration value is $1.06342 rounded down to $1.0634. Note the difference between the floor and ceiling: 1.0679 – 1.0579 = 0.0100, i.e., 100 pips. Hence 100 x $1.00 and thus explains how the contract is valued by the pip. Each pip move is a $1.00 move.

In the following examples, assume that the trader entered at the expiration value.

If a trader expects EURUSD to be above $1.06342 the cost of entry is the ceiling less the expiration value: $1.0679 – $1.0634 = 0.0045 pips, hence $45.00 per contract. If the contract expires in the money, the contract is worth $100.00, and the trader gains $100 less the cost of entry (which was $45.00) for a profit of $55.00. If it expires at or below the expiration level, the contract has no value and the trader is out the cost of entry, $45.00.

Conversely, if the trader expects EURUSD to be at or below the expiration value, the position is entered by selling the bid. The potential premium is the expiration value less the floor: $1.0634 – $1.0579 = 0.0055 pips or $55.00 per contract. Should the contract expire at or out of the money, its value is $0.00 and the realized gain is $55.00. If it expires in the money, the contract expires at the full $100 value, and the trader (seller) owes the buyer of the contract $100; the $55 dollar unrealized premium plus an additional $45.00 per contract. Hence a loss of $45.00 per contract.

In either event, long or short, both gains and losses are limited.

Why should floor, ceiling and expiration value be of interest the options trader? Because floor and ceiling prices relative to the expiration value may be viewed as market participants generating the probabilities that the binary will expire either in, out or at the money. In the example, the market generated a probability of 45% that EURUSD would be above $1.0634 at 2 p.m. and 55% that it would be at or below that value at 2 p.m.

The expiration value calculation is a simple average. For example, the NADEX calculated Forex expiration value uses the previous 10 midpoint prices in the underlying market, tosses out the three highest and three lowest midpoint prices, then averages the remaining four midpoint prices to the next decimal place past the precision of the spot price. This calculated underlying expiration value may be thought of as the ‘strike price’. In this example it’s $1.0634, rounded down from the arithmetic average of $1.06342.

Naturally, your trading platform will display all the relevant pricing in real time by way of a pre populated ticket.
Once the basics of binary options are grasped, the trader has a tool to collar profits, hedge against losses, speculate or enhance a portfolio return.

Mike Scrive

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