How a Nadex Binary Price Reflects Probability of Expiring In The Money, ITM
The price of a binary tells you it's probability of expiring in the money, ITM or profitable. If you are buying a binary and the price of the binary is $85, then there is an 85% chance of it expiring ITM.
Say it was the binary US 500 (Sep) >1953.0 (4PM), when you buy it you are basically saying that the binary statement is true, i.e. that the underlying market, Futures Emini S&P 500 (ES 09-14), will be greater than 1953.00 at 4PM. If you bought it and the statement does become true, then the trade is profitable.
Since a single Nadex binary is worth $100, that’s an 85% chance it will expire ITM, reaching $100 and be profitable for $15 for a greater than a 17% ROI. That is based on one contract of the binary; you can always buy more contracts. Is the pricing of the binaries on Nadex really a true reflection of the probability of expiring in the money? Yes.
Let’s take our example above of buying a binary for $85. If the price is truly reflective of probability of expiring in the money, which would mean out of 100 trades, 85 of them would win and make $15 for a total of $1275.
That high probability is nice, isn’t it? If you are thinking that now you’re only going to trade the higher priced binaries, consider what your net profit would be out of 100 trades. It would also mean that 15 of them would lose, and the loss per trade would be $85 for a total of -$1275. Remember, 85 won $1275 but the other 15 lost $1275.
That strategy would give you a net profit of 0 or breakeven. The spreadsheet below shows the same scenario with other prices besides $85 and $15, to see how the other examples add up as well. This example also shows that in order to achieve any positive net profit, you must exit before expiration.
Otherwise, continually letting trades expire will only get you breakeven results after 100 trades. With Nadex, you can exit at any time to take profit or control loss.
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It shows the probability of the binary expiring in the money, not necessarily of the trade being profitable. For example, what if the price of the binary you are buying is only $15?
The market is still below your binary strike price, but you’re buying it because you think the market is going to go up. This would be called an out of the money or OTM binary because the market is not above your strike price yet, so therefore, it’s not ITM yet. Does that mean your chance of being profitable on the trade just went down to 15%?
No, 15% is the probability it will expire ITM based on where the underlying market is now. There will be fluctuations in the market for which the price of the binary has no reflection of; it only reflects the probability of expiring ITM based on the price showing in the moment.
If you entered the trade because you anticipated the market to go up and it did, then you can always exit before expiration, to take profit, before it oscillated and went down again. For example, if the market moved favorably in your direction, and the price went from $15 to $40, you could exit at $40 with a $25 profit. Remember, you can trade more contracts. This example just shows the numbers based on 1 contract.
Let’s reverse it now. We’ll assume you are selling the same binary US 500 (Sep) >1953.0 (4PM), instead of buying it. You believe the statement to be false at expiration and that the underlying market will be at or below 1953.00 at 4PM.
Let's say you sold it for $15, because you think the market it going to go down between the time you entered and 4PM. Having only a 15% chance of expiring ITM in this case is great, you want it to go down.
As soon as it does and it reaches a planned profit amount, you can exit before expiration. Should the market turn and go up, you can also exit early to manage risk and avoid a full $85 loss.
When you sell a Nadex binary, $100 minus your entry price is the amount you put up for the trade and your total risk. When you buy a binary, the entry price is your total risk.
This example shows how Nadex binary prices are reflective of probability of expiring ITM or profitable at expiration, and you always have the option to exit early to take profit and/or control loss. APEX Investing Institute teaches traders the essentials and strategies on how to trade Nadex binaries. The free APEX Binary Scanner Analyzer allows you to see the best binaries for your strategy.
To learn more about how to trade binary options in-depth and for binary options signals, trading strategies, tools and trade rooms see ApexInvesting.com.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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