Underlying Factors to Consider When Pricing Binary Options
Many people believe that binary options trading is easy because all that a binary options trader has to do is predict correctly the direction of the value of the underlying asset –binary option trades are not as speculative as trades in other options. However, to be successful in binary options trading, there is need to understand the factors determining the value of the option. This is important because trading in binary options is all about predicting the fluctuations and the direction of the underlying asset.
The value of the option is mainly determined by the time value of the option and the intrinsic value of the option, but also the value of the underlying asset in some cases. The intrinsic value of the option means the amount of money by which the strike price would be above the pre-determined amount if the buyer were to exercise his/her option. The intrinsic value of the option is either calls option intrinsic value which is when the value of the underlying asset is greater than the strike price of the call, or put option intrinsic value which is whenever the strike price of the put is greater than the value of the underlying asset. It is important to note that trades out-of-the-money or at the exact value of the underlying asset do not have an intrinsic value.
On the other hand, the time value is the amount of money by which the value of the option is over the intrinsic value, but only before the pre-determined expiration date. In other words, the time value is the difference between the amount of money the buyer is willing and able to pay for the binary option and the intrinsic value of the option. Note that the longer the time to the expiration date, the greater the chance of a digital option trade to close in positive territory. Because options decay exponentially based on the rule of time component, we see that most options lose up to 1/3 of their value in the first half within the expiration time and lose 2/3 within the other half. However, this rule is not written in stone and there are fluctuations even in binary option trades that obey this rule.
The factors that influence the time and the intrinsic value of the option are the strike price, the price of the underlying asset, the expiration date and the volatility. The strike price is the major determinant of whether the option will have an intrinsic value. This can be interpreted to mean the more the binary option is in-the-money, the higher the price of the option, and vice versa. The effect of the underlying asset can be interpreted to mean when the price of the underlying asset increases, the value of the put option decreases and the value of a call option increases.
The expiration time affects the time value of the option in that it decreases this time value as the expiration date nears. Finally, the volatility of the underlying asset affects the direction of the value of the underlying asset in that the higher the volatility, the greater the fluctuations.
