Binary prices a proxy for probability

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Toby Geoffrey Robinson
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1 Binaries can be used to take a view on the short term volatility of key markets, giving a trader the potential to profit even without committing to a particular market direction. And, as usual with Binaries, this can be achieved with only limited collateral, with strictly capped risk and without the danger of being stopped out by a temporary adverse move. This presentation shows you how to use Binaries, either singly or combined, to build strategies that take advantage of expected high or low volatility in an underlying market. Futures trading and options trading involve risk, which may result in financial loss, and are not suitable for everyone. Any trading decisions that you may make are solely your responsibility. The information presented herein is for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular financial instrument offered on Nadex.

2 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 Binary prices a proxy for probability The price of a Binary can be thought of as the market s consensus belief that the Binary s outcome will occur. Uncertainty about a market outcome is driven by two factors: how volatile the underlying market is predicted to be, and how much time remains before expiration. For short term Binaries the more important of these factors is usually time to expiration. The charts below show how time affects typical US 5 Binary prices, in a situation where predictions of future volatility remain constant and the underlying CME E-mini S&P 5 Futures* remains at a level of 125. As an example, take a look at the evolution in price of the >1244 Binary (circled). The price rises from 72 to 8 to 89 to 99 as time to expiration falls from 12 hours to 6 hours to 3 hours to 1 hour, reflecting increasing certainty in the market (72% to 8% to 89% to 99%) that the underlying futures will be above 1244 at the expiration time of the Binary. Another way of putting this is that the market perceives a much lower chance of the futures dropping 6 points in 1 hour (1%) than dropping 6 points in 12 hours (28%) hours to expiration hours to expiration hours to expiration hour to expiration * S&P 5 is a registered mark of the McGraw-Hill Companies, Inc. CME and E-mini are registered marks of the Chicago Mercantile Exchange Inc. Nadex is not affiliated with these organizations and neither they nor their affiliates sponsor or endorse Nadex or its products in any way.

3 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 Selling volatility using Binaries: Some trading strategies Imagine that Nadex s participants believe that volatility in the CME E-mini S&P 5 Futures will be typical between now and expiration in 12 hours time. The consensus view of these participants might lead to a pattern of US 5 Binary prices like those graphed below. However you, as a trader, believe that the market is trapped in a tight range and in 12 hours time will be at or very close to where it is now (125). In other words, while other traders are predicting a normal amount of volatility over the next 12 hours, you are making a very strong assumption about very low actual volatility during that time. Potential trades that would profit if this low-volatility prediction proves accurate are easy to see: 12 hours to expiration If the market does not move, these contracts will increase in value to 1 during the next 12 hours; a trader foreseeing low volatility might choose to buy them This contract will settle at either or 1, depending on whether Nadex s calculated Expiration Value falls at/below 125 or above 125; a volatility trader has no interest in this coin toss If the market does not move, these contracts will decrease in value to during the next 12 hours; a trader foreseeing low volatility might choose to sell them But this approach is too simplistic. In reality, a trader cannot be certain in advance that the underlying market will remain static, or nearly static, until expiry. In reality, a trader interested in selling volatility needs to weigh the potential payoff from selling volatility against the potential cost of an unexpected sudden market move. The next few slides give some examples of strategies that a seller of volatility might pursue, depending on that trader s risk appetite and strength of opinion.

4 Selling volatility: Long 5 lots of 73.9, short 5 lots of 26 (= $26.5) (= $239.5) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at Current market (= 125) Collateral required to enact this intraday binary strategy: $239.5 In this simple strategy, the trader is going long the >1244, on the assumption that its price will grow towards 1 as expiration approaches (because he expects the futures market will remain above 1244 during that time). He is also going short the >1256, on the assumption that its price will decay towards zero as expiration approaches (because he expects the futures market will remain below 1256 during that time). Assuming the position is held until expiration, each >1244 contract purchased would risk $73.9 to potentially make $26.1. Each >1256 contract sold would risk $74 to make $26. Because the trader must profit on at least one of these contracts (i.e. the futures cannot be both below 1244 and above 1256 in 12 hours time) his total risk in trading one lot of each of these is $47.9 ($26.1 minus $74 if the futures are above 1256 or, alternatively, $26 minus $73.9 if the futures are below 1244). In this example 5 lots of each contract are being traded, so the trader s maximum possible loss (and total required collateral) is 5 x $47.9 = $ On the other hand, so long as the Expiration Value lies between 1244 and 1256 he stands to profit on both legs of the position, making ($ $26) x 5 = $26.5.

5 Selling volatility: Long 5 lots of 63.1, short 5 lots of 36.1 (= $365) (= $135) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at 125 Current market (= 125) Collateral required to enact this intraday binary strategy: $135 In this strategy, the trader is going long the >1247 and going short the >1253. Assuming the position is held until expiration, each >1247 contract purchased would risk $63.1 to potentially make $36.9. Each >1253 contract sold would risk $63.9 to make $36.1. Because the trader must profit on at least one of these contracts his total risk in trading one lot of each of these is $27 ($36.9 minus $63.9 if the futures are above 1253 or, alternatively, $36.1 minus $63.1 if the futures are below 1247). In this example 5 lots of each contract are being traded, so the trader s maximum possible loss (and total required collateral) is 5 x $27 = $135. On the other hand, so long as the Expiration Value lies between 1247 and 1253 he stands to profit on both legs of the position, making ($ $36.1) x 5 = $365. So the ratio between potential profit and potential loss is very much more favorable than in the preceding example. But this needs to be weighed against the greater risk it is much less likely that the futures will be within the range than within the range in 12 hours time the trader is aiming at a smaller target here, so gets a greater reward if he is right.

6 Selling volatility: Long 5 lots of 95.3, short 5 lots of 4.9 (= $48) (= $452) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at Current market (= 125) Collateral required to enact this intraday binary strategy: $452 In this strategy, the trader is going long the >1235 and going short the >1265. Assuming the position is held until expiration, each >1235 contract purchased would risk $95.3 to potentially make $4.7. Each >1265 contract sold would risk $95.1 to make $4.9. Because the trader must profit on at least one of these contracts his total risk in trading one lot of each of these is $9.4 ($4.7 minus $95.1 if the futures are above 1265 or, alternatively, $4.9 minus $95.3 if the futures are below 1235). In this example 5 lots of each contract are being traded, so the trader s maximum possible loss (and total required collateral) is 5 x $9.4 = $452. On the other hand, so long as the Expiration Value lies between 1235 and 1265 he stands to profit on both legs of the position, making ($4.7 + $4.9) x 5 = $48. So the ratio between potential profit and potential loss is very much worse than in either of the preceding examples. But, again, this needs to be weighed against the greater probability of success for the strategy it is very likely that the futures will be within the range in 12 hours time. The trader is aiming at a very large target, 3 full futures points wide, so his payout for hitting it is small in comparison to the cost of missing it.

7 Selling volatility: Long 2 lots of 73.9, long 3 lots of 63.1, short 3 lots of 36.1, short 2 lots of 26 (= $23.2 or $323.2) (= $176.8) Current market (= 125) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at 125 Sell 2 Sell 3 Buy 3 Buy 2 Collateral required to enact this intraday binary strategy: $176.8 This is a more complex strategy, designed to stretch the size of the target while still providing an impressive payout in the event of a bull's-eye. The dotted line shows the payout for a simple buy 5 lots of >1247, sell 5 lots of >1253 strategy. As previously seen, the strategy pays out a potential $365 profit, but the end of day target for the futures market is just 6 points wide. Any settlement outside this range results in a loss of $135 (assuming the trader does not exit the position early). By splitting each side of the strategy between two contracts, the safe zone, where the trader avoids making a loss, doubles in width from 6 points to 12 points. The cost of this wider target is the lower potential payout for success (much lower in the outermost 6 points of the range) and the slightly higher potential loss outside the range.

8 Selling volatility: Exiting a position early Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at hours later, the market has risen 6 points Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at 1256 (= $26.5) (= $239.5) All of the previous examples were illustrated by payout diagrams that assumed the strategy in question would be held to expiration. It is worth noting that the pattern of potential profits or losses can be far less extreme if the trader exits the strategy early. In this example the trader exits early, with 6 hours remaining before expiration, as the market begins to drift out of his target range. He loses = 25.4 points on his short >1256 position and makes = 2.3 points on his long >1244 position, for a total net points loss of 5.1, corresponding to a cash loss of $51. Initial market (= 125) Market 6 hours later (= 1256) Collateral required to enact this intraday binary strategy: $239.5 A loss of $51, although undesirable, is at least an improvement on the loss of $239.5 that the trader would see if he were to hold on to the strategy and the underlying market were to settle outside his target range.

9 >1223 >1226 >1229 >1232 >1235 >1238 >1241 >1244 >1247 >125 >1253 >1256 >1259 >1262 >1265 >1268 >1271 >1274 >1277 >128 Buying volatility using Binaries Binaries can also be used to build strategies that can profit in the event of unexpectedly high volatility, even if a trader is unsure as to whether this volatility will manifest itself as a large upward move in the market or a sudden and dramatic decline. To buy volatility, rather than sell it, a trader simply needs to reverse the direction of the preceding strategies. Returning to the example of US 5 Binaries, where Nadex s Expiration Value is calculated by reference to the CME E-mini S&P 5 Futures: 12 hours to expiration If the market makes an unexpected downward move, some or all of these contracts may decrease in value dramatically; a trader foreseeing high volatility might choose to sell them This contract will settle at either or 1, depending on whether Nadex s calculated Expiration Value falls at/below 125 or above 125; just as before, a volatility trader has no interest here If the market makes an unexpected upward move, some or all of these contracts may increase in value dramatically; a trader foreseeing high volatility might choose to buy them A trader unsure of market direction, but sure that the market will do something dramatic over the next few hours, would build a strategy covering both sides of the market, selling one or more contracts with strikes below 125 and buying one or more contracts with strikes above 125. Just as in the case of selling volatility, there are a huge number of potential strategies and the most attractive one for a particular trader will depend on that trader s risk appetite and strength of conviction. A trader interested in buying volatility needs to carefully weigh the cost of buying that volatility against the risk that the market fails to make any kind of dramatic move.

10 Buying volatility: Short 5 lots of 6.1, long 5 lots of 4.1 (= $1) (= $4) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at Current market (= 125) Collateral required to enact this intraday binary strategy: $4 In this strategy, the trader is going short the >1247 and going long the >1253. Assuming the position is held until expiration, a settlement value greater than 1247 but no greater than 1253 would result in a loss to the trader of $4. But a move of more than 3 points in either direction would generate a payout of $1. The trader in this case is risking a lot in comparison to the potential reward. This reflects the fact that, according to this initial set of Binary prices, other Nadex participants believe it is more likely than not that the CME E-mini S&P 5 Futures will move more than 3 points in 12 hours.

11 Buying volatility: Short 5 lots of 92.3, long 5 lots of 7.8 (= $422.5) (= $77.5) Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at 125 Current market (= 125) Collateral required to enact this intraday binary strategy: $77.5 To take a more extreme view on high volatility, a trader could short the >1235 and go long the >1265. Assuming the position is held until expiration, a settlement value greater than 1235 but no greater than 1265 would result in a loss to the trader of $77.5. But a move of more than 15 points in either direction would generate a payout of $ The trader in this case is risking little in comparison to the potential reward. This reflects the fact that, according to this initial set of Binary prices, other Nadex participants believe it is pretty unlikely that the CME E-mini S&P 5 Futures will move more than 15 points in 12 hours.

12 Buying volatility: Exiting a position early Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at hours later, the market has risen 1 points Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > Daily US 5 (Mar) > hours to expiration, futures trading at 126 No action (= $422.5) (= $77.5) Initial market (= 125) Market 6 hours later (= 126) Collateral required to enact this intraday binary strategy: $77.5 Again, note that these examples have so far assumed an all or nothing approach of holding the strategy until expiration. By exiting early it is possible for a trader to generate profits or losses that lie between the extremes on these diagrams. In this example the trader was proven partially correct; the market has risen 1 points, with 6 hours remaining before expiration. If, at this point, he believes a further move is unlikely, he might choose to exit from the >1265 leg of the strategy by selling at 22.2 while leaving the lower >1235 to run (this lower contract is bid at 98 and has no offer, so there is little value to be extracted by trying to buy it back). This realizes a profit of ( )*5 = $72 on the >1265. Assuming the >1235 settles at 1, losing the trader $38.5, he will still walk away with a net profit of $33.5 over the whole strategy (note: an extremely small chance exists that the market will fall 25 points in the remaining 6 hours, leading to an additional profit of $461.5 on the >1235 ).

13 Range of Markets We offer contracts on: Equity Indices: US 5, Wall Street 3, US Tech 1, US SmallCap 2, Germany 3, Korea 2, Japan 225, FTSE 1 Spot FX: Energies: Metals: Agriculturals: Economic Events: EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, GBPJPY, EURJPY Crude Oil, Natural Gas Gold, Silver, Copper Corn, Soybeans Initial Jobless Claims, Fed Funds, ECB Rate, Nonfarm Payrolls, Unemployment Rate Futures trading and options trading involve risk, which may result in financial loss, and are not suitable for everyone. Any trading decisions that you may make are solely your responsibility. The information presented herein is for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular financial instrument offered on Nadex.

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