Binary options are a different investment type so to have a prosperous trading system then it will differ from those of the standard assets. By examining the math behind the instruments, we can help move the trader along the path of creating a useful trading system. Binary options are short term investments that return only one of two possible payouts at expiration; they are either in or out of the money.
A well known binary is the above/below option, which locks in the current market price of the asset as the strike price. If, at expiration, the binary’s price is above the strike price in the case of a call, or below the strike price in the case of a put, then the option finishes in-the-money and the option buyer receives the maximum payout. If not, a smaller payout is received.
For example, if the current level of the FTSE 100 Index is 6051.718, an investor can go to the webpage of the trading platform, enter the desired investment amount, say $100, and click “Call” or “Put” to obtain an option that expires in approximately 40 minutes. Next, the platform indicates the payout will be $185 (including the invested $100) if the investor bets right, or nothing if wrong.
As with any asset, traders using binary options should be systematic. Yet, the unique features of binary options make creating a trading system simpler. For example, in most cases, binary options can only be purchased, not sold – and the payouts are fixed. In addition, a binary option is automatically closed at expiry and normally can’t be closed before expiration. Therefore, a trading system need only indicate which particular options to trade, when to buy a call or put, and how much to risk on the position.
For this analysis, let us look at only the above/below option, however many results can be extended to other binary options. binary options have only two results and have no fees or commissions, their performance can be illustrated mathematically.
For starters, the dollar value of your trading account is VAL. From this account, you always invest the same amount to trade INV, usually these are small amounts. If the binary option finishes in-the-money, implying profit, your payout is PW – the loss payout is called PL. Thus a binary option has a payout matrix of 75% plus stake for a win, 10% of stake for a loss, then PW = 1.75 and PL =0.1. We’ll assume that these payouts are fixed across all option trades that are made.
The value of your account, VALt, after t option trades is given by:
VALt = VALt-1 + [þt PW + (1 – þt) PL – 1] INV
Where VALt=0 = starting balance.
The stochastic variable, þ, can have only one of two values: “1” meaning that the binary option finishes in-the-money (you profit), or “0” meaning that the binary option finishes out-of-the-money (you lose).
So the value of your account at any time depends on the success or failure of prior trades. It should not surprise you that the value of your account can evolve, even for the same ratio of winning and losing trades, because the trades happen in different orders.
Next, the success ratio of a trading system, SR, after t binary option trades is simply:
SRt = (S þt)/t
This means that if 25 out of 40 trades are winners, the success ratio of the system is 62.5%. With these assumptions and model, let’s look at trading.
If you just merely guess, then a trading system provides no value in improving the success ratio beyond the expected value of þ, E(þ) which in the case of above/below option, E(þ) equals about 0.5 or 50%. Therefore, an above/below binary option based on pure guessing is equally likely to win or lose. Far worse, is the threshold binary option – which is the price of the asset must rise or fall to some designated level for the option to finish in-the-money – because it has an expected value of þ that which is less than 50%, because it is simpler to make a mistake.
Well than what does this all mean? Here to summarize a successful trading system then consider these points:
a) The system has to generate more successful profitable trades than losing trades. This is unlike stocks and commodities in which a minority of winning trades, if they win big enough, will offset portfolio losses. In addition, the success ratio does not have to be humongous. Most of the time, a system need only generate a marginally higher success ratio than 50% to break even. Success ratios higher than 50% break-even mean improved profit performance.
b) The usefulness of a system requires high volumes of trades because the more trades, the more precisely the success ratio can be determined. Yet with binary options this does not have to be expensive leaving the bulk of your initial capital untouched.
c) The only way to determine the viability of your trading system is to keep investment amounts low. You have to expect a series of losses. Your system needs to withstand this without financial meltdown. So set initially a target of just 5 to 10% of your portfolio to start trading.
d) Reverse the trade decision, e.g. buy a put instead of a call and vice versa. This basic change in tactics is not possible in other asset classes.
The beauty of the binary option is its’ low capital expenditure and predetermined outcome. You know from the beginning your risks and rewards. This low threshold allows you to really experiment and find a trading system after multiple trades which can bring you the profits you desire.