Lesson: Statistical Probabilities Of In-The-Money Binary Options
This article was written by Tommy O’Brien.
With earnings season still in full swing there are many news events moving the markets every trading day. Along with earnings, we also have the usual economic announcements like the non-farm payroll Friday morning at 8:30 am ET. The street is expecting 200K jobs will be added.
There are many ways to trade news announcements, one of which is the binary option market. When trading binary options you have the benefit of defined risk with the ability to diversify your trading portfolio.
The risk vs. reward of any trade is an important part of being profitable. When trading binary options your risk is always defined, and so is your maximum profit. Binary options are worth $100 if they expire in-the-money and worth $0 if they do not.
Here is a chart of the Wall Street 30 as of Thursday at 4 pm ET, Which is based on the CBOT E-mini Dow Futures. Along the right axis are some of the weekly binary options available that expire on Friday at 4:15 pm ET, with about 24 hours and 15 minutes remaining.
One trade possibility if you had a flat to bullish market bias would be to buy an in-the-money binary option, which would be a higher probability trade as the underlying market is above the strike. One binary option you could buy is the deep in-the-money >17,375 for $90. Your defined risk would be the $90 per contract that you initially pay, and your maximum profit would be $10 if the binary option expires in-the-money for $100 of total value. You would be risking $9 for every $1 of potential profit.
While the math seems easy on this one single trade, it’s important to be aware of the probabilities of multiple losses and wins. Assuming you have a 90% chance of success on this trade, since that’s what the market is pricing it at, then you will be profitable making this trade 9 out of 10 times.
If you make 7 trades every day with this same 90% chance of success then you will actually be less than a 50% favorite to be successful in all of them consecutively (0.90 x 0.90 x 0.90 x 0.90 x 0.90 x 0.90 x 0.90 = 47.83%). When you risk $90 to only make $10 it can hurt badly when that loss shows its ugly face. You should always be calculating the probabilities of differing scenarios playing out, especially when you have money at risk. The reason for having to risk $9 in this trade to make every $1 in potential profit is because you have about 194 Dow 30 points of premium that the index can move against you while still in-the-money.
If you wanted to risk slightly less to shift the potential reward in your favor then you could choose to buy the binary > 17,475 strike for $74. Your risk for this contract would be capped at the $74 you initially pay and your maximum profit would be $26 if it expired in-the-money. In this potential trade you would be risking about $2.85 for every potential $1 in profit with about 94 Dow points of premium in your favor. With a theoretical 74% chance of success your probability has dropped yet so has your maximum risk.
If you made 3 trades each day with each having a 74% chance of success then you would have a 40.52% chance of 3 trades being consecutively profitable (0.74 x 0.74 x 0.74 = 40.52%). Even making 2 consecutive successful trades, with each one having a 74% chance of success, is only barely a favorite at 54.76% (0.74 x 0.74 = 54.76%). If you felt the opposite on this trade and thought the market would be negative to flat tomorrow then you could also sell a binary option above the current market for a similar inverse strategy. If you sold the >17,775 binary option for $9 then your maximum profit would be capped at the initial sale price while your maximum risk would be $91 ($100 expiration value – $9 initial sale price). Even at a 91% chance of success you should prepare for the inevitable loss and always be aware of the probabilities of your trades.
Making higher probability binary option trades can be something to consider possibly the next time you’re scanning the market for profitable set-ups. When trading anything with a defined risk vs. reward you always want to be calculating your chances of success and the probabilities of future events occurring. Understanding the math and probability of your possibly investment will help you become a more profitable trader.
Note: Exchange fees excluded for calculations.
Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.
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