Trading Volatility with Binary Options

Trading Volatility with Binary Options

Submitted by adil on Fri, 07/25/2014 - 12:38

What Elements Affect Volatility?

The elements that are used to determine the options pricing of binary options are the same as typical options. These elements include time frame, volatility, exercise price and the underlying security. All of these elements carry great importance as they affect the pricing of the options. However, in order to understand how volatility is traded using binary options, let’s look at how the traders can take advantage of the short term opportunity associated with trading volatility using binaries. Binary options pricing is basically defined with the mutual understanding of the market, according to which there will be a certain result during a fixed period of time. For example, the market expects that the underlying asset will be above 1250 at 1400 EST the next day.

The pricing of binary options will approximately be 50 if its exercise price is at or near the market price of the underlying asset. As you already know, the value of the binary at the time of expiry is 100 dollars per contract, so in this case, the buyer and seller of the binary contracts do not get any benefit from it instantly as its half of the actual worth of the contract.

Types of Volatility

Historical volatility and implied volatility are two types of volatility.

Historical volatility – represents how the underlying price kept changing in the past during a certain period of time, whereas;

Implied volatility – represents the expectations of the current market about the future performance of the underlying.

Trading Volatility

Selling Volatility

If the trader believes or expects that market of the underlying asset will not move or that it will stay within a defined range, then binary options can prove to be a useful choice to earn potential profits based on the traders’ perception. If the trader believes that the exercise price of the binaries is in-the-money, it represents that the greater portion of the contract value (i.e. 100 dollars) at the time of expiry consists of initial cost.

If you take advantage of this binary strategy, you can either trade the exercise price of binary options outright, which will be in-the-money, or a combo trade can be produced by you where both the tails will be in the money.

However, if the market stays stagnant and remains within the range of two exercise prices, a trader can earn double profit. But, one of the tails will always remain in-the-money at the time of contract expiry.

Buying Volatility

On the other hand, if a trader believes or expects that there will be volatility in the market of the underlying asset and therefore, carefully trades in the market due to the expected risk, then binary option trading can be profitable for him based on his perception. The exercise price of these binary options will be out-of-the-money, meaning the initial cost will constitute a small portion of the contract value (i.e. 100 dollars) at the time of expiry.

Therefore, if you take advantage of this binary strategy, you can either trade the exercise price of binary options outright, which will be out-of-the-money, or you have a choice to form a combo trade where both the tails of the binary will be out of the money.