Consider the following bets:
- Pay $45 to bet gold will be above $1,700 at 1:30 p.m. today. Get $100 ($55 profit) if you win, lose $45 otherwise.
- Receive $81 now to bet the NASDAQ 100 will drop below 8600 at 2 p.m. today. Keep a profit of $81 if your prediction comes true. If not, lose $19.
- Pay $77 to earn $100 if the USD-JPY exchange rate rises above 108 at 3 p.m. today; you lose $77 if it doesn’t.
Welcome to binary options. All or nothing, one or zero, these titles are available on Nadex. Binary options allow traders to make time-limited conditional bets on predefined values of stock indices, currencies, commodities and events. Like a standard exchange-traded option, each binary option has an option premium ($45, $81, and $77 in the examples above), a predetermined strike price ($1,700, 8,600 points, and 108 yen) and an expiration (1:30 a.m., 2 p.m., 3 p.m. today).
The differentiator is the settlement price which remains fixed at $0 or $100, depending on which option condition is met. It keeps the net profit (or loss) fixed. The option premium also remains between $0 and $100. (Related: Binary Options Trading Guide.)
Calculate the probability
Since binary options are time-limited and condition-based, probability calculations play an important role in the valuation of these options. It all boils down to “What is the probability that the current gold price of $1,220 will rise to $1,250 or higher within the next four hours? Determining factors include:
- Volatility (how much, and is it enough to cross the threshold/strike price?)
- The direction of price movement
- Hourly
Technical indicators suitable for binary options trading should incorporate the above factors. One can take a binary option position based on detecting continuous momentum or trend reversal patterns. Let’s look at some of the popular binary options technical indicators.
Wilder’s DMI (ADX)
Comprised of three lines, namely ADX, DI+ and DI-, and their relative positions, Wilder’s Directional Movement Indicators (DMI) Average Directional Index (ADX) aims to capture the strength of an already identified trend. . Below is the trend interpretation chart.
| Position | Momentum | ADX value > 25 | ADX value < 25 |
| DI+ above DI- | Indicates an uptrend | Strong uptrend | Weak and unsustainable uptrend |
| DI- above DI+ | Indicates a downtrend | Strong downtrend | Weak and unsustainable downtrend |
Here is an illustration, using stock from 3M Company (MMM):
Depending on the momentum identified and the strength of the trend, an appropriate buy/sell position could be taken.
pivot point
Pivot point analysis (in conjunction with support and resistance levels) helps determine trends and directions for a given time period. Due to the flexibility of timing, pivot points can be used for binary options, especially for trading highly liquid major currencies. A good example (with calculation and charts) is included in Using Pivot Points in Forex Trading.
Product Channel Index (CCI)
The CCI calculates the current price level of a security relative to the average price over a given time period. The average price level is usually the moving average. Time periods can be selected as desired allowing the trader to choose when a binary option expires. The CCI is useful for identifying new trends and extreme conditions of overbought/oversold securities.
It is very popular among day traders for short-term trading and can be used with additional indicators such as oscillators. In the formula below, “price” is the current price of the asset, “MA” is the moving average of the asset price, and “D” is the normal deviation from that average. High values above +100 indicate the start of a strong uptrend. Values below -100 indicate the start of a strong downtrend. The CCI is calculated with the formula:
ICC
=
Price
−
MY
0.015
×
D
where:
Price
=
current asset price
MY
=
asset price moving average
D
=
normal deviation from the moving average
\begin{aligned} &\text{CCI} = \frac { \text{Price} – \text{MA} }{ 0.015 \times \text{D} } \\ &\textbf{where:} \\ &\ text{Price} = \text{current asset price} \\ &\text{MA} = \text{moving average of asset price} \\ &\text{D} = \text{normal deviation relative to the moving average} \\ \end{aligned} ICC=0.015×DPrice−MYwhere:Price=current asset priceMY=asset price moving averageD=normal deviation from the moving average
Stochastic oscillator
In an interview, the creator of the Stochastic Oscillator, Dr. George Lane, said “it follows the speed or momentum of price. Typically, momentum changes direction before price. This important underlying detail indicates extreme cases of overbought and oversold, helping to identify bullish and bearish phase reversals The crossing of %K and %D values indicates trade entry signals Although a 14-day period is standard, binary options traders can use their own timeframes.
%K
=
100
(
VS
−
L14
H14
−
L14
)
where:
VS
=
most recent closing price
L14
=
low of the previous 14 trading sessions
H14
=
highest price traded in the same 14 day period
\begin{aligned} &\text{\%K} = 100 \left ( \frac { \text{C} – \text{L14} }{ \text{H14} – \text{L14} } \right ) \ \ &\textbf{where:} \\ &\text{C} = \text{most recent closing price} \\ &\text{L14} = \text{lowest of previous 14 trading sessions} \\ &\text{ H14} = \text{highest price traded in the same 14 day period} \\ \end{aligned} %K=100(H14−L14VS−L14)where:VS=most recent closing priceL14=low of the previous 14 trading sessionsH14=highest price traded in the same 14 day period
%D
=
3 period moving average of %K
\begin{aligned} &\text{\%D} = \text{3-period moving average of \%K} \\ \end{aligned} %D=3 period moving average of %K
Levels above 80 indicate overbought, while those below 20 indicate oversold.
Bollinger Bands
Bollinger Bands capture an important aspect of volatility. They identify upper and lower levels as dynamically generated bands based on a security’s recent price movements.
Commonly followed values are 12 for the simple moving average and two for one standard deviation for the upper and lower bands.
The contracting and expanding bands indicate reversal signals that help traders take appropriate positions in binary options. Overbought situations are indicated if the current market price is above the upper band. While oversold is indicated when the current market price is below the lower band.
A challenge in binary options trading is to correctly predict the durability of a trend over a given period. For example, a trader might take the correct position for an index, predicting that it would reach 1,250 at the end of a five-hour period, but the level was reached within the first two hours. Constant monitoring is required for the remainder of the three hours if the trader plans to hold the position until it expires, or if a pre-determined strategy needs to be executed (such as squaring the position) once the level is reached.
The essential
The technical indicators discussed above should be used for timely actions with constant monitoring. A major drawback of technical indicators is that the results and calculations are based on past data and can generate false signals. Traders should tread carefully with detailed backtesting and in-depth analysis of high-risk, high-reward assets like binary options.