Binary Options - how much is opium for the people?
Binary options the instrument for investors is quite new. The practice is not settled. The mathematics, however, is not either. Therefore, there is a truly mythological atmosphere around these derivative financial instruments, which cannot but alarm inquisitive minds of traders. In fact, everything is much simpler. A binary option is the same financial instrument as a traditional option contract. It is just that binary has a number of features and differences.
Other articles about options:
Binary options - almost familiar to traders
Recently, investors have started to use binary options more and more often in their operations in the financial markets. This is quite unusual, as these derivatives are exotic option contracts that cannot even be identified due to their colorful individuality. As a result exotic options are defined simply as all those that are not vanilla options (standardized option contracts traditionally traded on exchanges, as well as on the FOREX market).
However, even this definition is gradually becoming archaic. Since 2008, the Chicago Board Options Exchange (CBOE) has been offering binary options, which are a classic example of an European-style all-or-nothing options, began trading on the S&P 500 index, as well as on the index volatility VIX. To all appearances, these are only the "first swallows". We can expect that over time the range of binary options admitted to exchange trading will inexorably expand, as these derivatives have certain capabilities that vanilla options do not and cannot have.
These features are most prominently and vividly manifested in the American style binary options execution, which are currently actively used on OTC financial markets. First of all, on the currency market. Let me remind you that - American style of exercise involves exercising the option at any time prior to the expiration date of the option contract. While European style option is exercisable only on the expiration date of the contract. This circumstance (execution at any point in time) gives American binary options a significant expressiveness, expressed in the rapid dynamics of change in the value of the option depending on price shifts in the underlying asset that underlies the option.
Binary options math: is it necessary?
The math of binary options is quite complex compared to vanilla option valuation models. Therefore, it is extremely difficult to understand this analysis apparatus without knowledge of higher mathematics. However, whether investors intending to trade binary options need it is rather a philosophical question. Since all the practice persistently says that Knowing the math of binary options (as well as any other options) is not a prerequisite for successful work with them. Nevertheless, there are still some things to know.
The foundation of understanding the behavior of any options relates to the ability to read the so-called yield profiles. They are constructed as a relationship between the value of an option contract and the underlying asset or other factor that influences the option price. American-style binary options are simple in this respect. Their yield profile is uncomplicated and does not need any explanations (see Fig.1). The only thing that should be noted: binary options return profile is identical to that of the so-called delta of vanilla options of the same strike price as binary options, where the strike price often also appears as a barrier.
The three pillars of binary options success
In the overwhelming number of cases, the change in the value of an option depends precisely on the delta, which makes it possible to measure the rate of increase in the price of an option contract depending on the price fluctuations of the underlying asset. For vanilla options, this indicator ranges from 0 to 100%. While binars can have deltas of thousands of percent.. This fact is an extremely important difference between binary and vanilla options. So much so that traders brought up on stock options are shocked when they first come into contact with binary options (see Figure 2).
Along the way, going a little deeper into the wilds, we note the following. The difference between the delta of binary contracts and that of vanilla options is the result of the fact that the delta of binary contracts is identical to that of vanilla options, which is often regarded only as a sensitivity indicator of secondary importance. To say the same about binary, of course, is simply not possible.
Another crucial aspect is related to the fact that binary options have a much lower theta compared to vanilla options (theta is an indicator characterizing the rate of time decay of the option value). For example, such relatively short-lived binary options as one-month contracts on the currency cross rate have a theta half as low as that of a vanilla option with a strike price equal to the binary contract barrier. In other words, all other things being equal, including in terms of position risk management, the use of binars is likely to be more profitable than the use of vanilla options.
Actually, these two circumstances are the main arguments in favor of using binars as a worthy alternative to the use of traditional vanilla options.
True, there is another extremely important argument in favor of binary options. It has to do with the fact that it is impossible to lose more than a known amount of money when trading binars. Even when it comes to selling binary options. Since binars are always paired with mirrored contract performance conditions. For example, a long tangent binary (one touch) is identical to a short underdog (no touch). And a short tangent is identical to a long position in a non-touch (see Fig. 3).
This, alas, cannot be said about vanilla options when it comes to risk-adjusted short positions in options. It is no coincidence that there is a saying among traders: never sell your mother, motherland and options.
The article was prepared by Mikhail Chekulaev, author of the book "Financial Options." with the support of Saxo Bank