Here we have a binary option with a 25% probability (we will get to the bid and offer in a moment) with a buyer on the left and a seller on the right. You will be pleased to know on the Nadex platform each 1% of probability is equivalent to 1$, so every contract is $100 which makes the maths nice and simple.
We decide to buy this contract as we believe the market will close above the strike price by expiry. The cost of the binary is $25 (25 x $1). This is our total risk. We cannot lose any more than this on the contract. Our reward here is the difference between 100 and our risk, in other words $100 - $25 = $75. In buying this binary we are taking a 1:3 ratio of risk to reward which seems attractive, but the underlying price has to move for this to finish above the strike price. This is an out of the money binary option, and for it to move towards 100, the underlying price has to move. Risk and reward go hand in hand in all forms of trading and investing, but in binary options this has to be balanced by the time to expiry and the underlying analysis.
Now if we look at the opposite side of the position. We have bought at 25, so the exchange has matched a seller, who has sold at 75. Their risk/reward profile is the inverse of ours as the buyer. As a seller their risk is $75 and their profit is $100 - $75 = $25. Their risk to reward ratio is 3:1. You may wonder why anyone would want to trade with a risk to reward ratio of 3:1. This is similar to backing an odds on horse, and the reason is simply the probability. The seller has sold the option at 75%, as they believe there is little prospect of the option closing above the strike price. The same principles that work for the option buyer, also work for the option seller. Let me explain by taking two extremes of the binary option. The first at 90 and the second at 10 and assume both are relatively close to expiry.
In the first example, suppose we have a binary option trading at 90. The probability is very high the option will close at 100 and as an option buyer we are prepared to risk $90 to make $10. We are buying this binary option as we believe the proposition will close as true.
In the second example the binary option is trading at 10, and once again is close to expiry. The probability here is very low the proposition will close as true, so we are a seller of the binary option. As before we are risking $90 to make $10. The risk and reward profile is the same, but in one we are a binary option buyer, and in the other a binary option seller. However, in both cases our potential profit is $10 and our risk is $90. In both of the above examples we will be matched on the other side of the position with a seller in the first example and a buyer in the second. And just for completeness these examples are based on the assumption the underlying market is well away from the strike price and deep in the money.
If we return to our example in Fig 4.14, here the option buyer and option seller are matched and the exchange will hold the funds from both parties as the collateral for the contract. In total this will be $25 + $75 = $100. On expiry of the contract one party will receive $100 and the other will receive $0. If you think of the binary option on Nadex in these terms it makes the whole process very simple to understand. Buyer and seller are matched, and the total risk exposed by both parties comes to $100 per contract. You can of course buy or sell multiple contracts, but the same basic mathematics still apply.
We decide to buy this contract as we believe the market will close above the strike price by expiry. The cost of the binary is $25 (25 x $1). This is our total risk. We cannot lose any more than this on the contract. Our reward here is the difference between 100 and our risk, in other words $100 - $25 = $75. In buying this binary we are taking a 1:3 ratio of risk to reward which seems attractive, but the underlying price has to move for this to finish above the strike price. This is an out of the money binary option, and for it to move towards 100, the underlying price has to move. Risk and reward go hand in hand in all forms of trading and investing, but in binary options this has to be balanced by the time to expiry and the underlying analysis.
Now if we look at the opposite side of the position. We have bought at 25, so the exchange has matched a seller, who has sold at 75. Their risk/reward profile is the inverse of ours as the buyer. As a seller their risk is $75 and their profit is $100 - $75 = $25. Their risk to reward ratio is 3:1. You may wonder why anyone would want to trade with a risk to reward ratio of 3:1. This is similar to backing an odds on horse, and the reason is simply the probability. The seller has sold the option at 75%, as they believe there is little prospect of the option closing above the strike price. The same principles that work for the option buyer, also work for the option seller. Let me explain by taking two extremes of the binary option. The first at 90 and the second at 10 and assume both are relatively close to expiry.
In the first example, suppose we have a binary option trading at 90. The probability is very high the option will close at 100 and as an option buyer we are prepared to risk $90 to make $10. We are buying this binary option as we believe the proposition will close as true.
In the second example the binary option is trading at 10, and once again is close to expiry. The probability here is very low the proposition will close as true, so we are a seller of the binary option. As before we are risking $90 to make $10. The risk and reward profile is the same, but in one we are a binary option buyer, and in the other a binary option seller. However, in both cases our potential profit is $10 and our risk is $90. In both of the above examples we will be matched on the other side of the position with a seller in the first example and a buyer in the second. And just for completeness these examples are based on the assumption the underlying market is well away from the strike price and deep in the money.
If we return to our example in Fig 4.14, here the option buyer and option seller are matched and the exchange will hold the funds from both parties as the collateral for the contract. In total this will be $25 + $75 = $100. On expiry of the contract one party will receive $100 and the other will receive $0. If you think of the binary option on Nadex in these terms it makes the whole process very simple to understand. Buyer and seller are matched, and the total risk exposed by both parties comes to $100 per contract. You can of course buy or sell multiple contracts, but the same basic mathematics still apply.
