Using Binary Options to Forecast Market Direction

Binary options have been around for a couple of years. There are binary options on some of the more highly traded stocks and ETFs such as Apple, Microsoft, and QQQQ. These are offered on the AMEX, but so far there are only two binaries offered on the CBOE—the SPX, the S&P 500 index, and the VIX, the volatility index.

What are binary options?
Binary options are an all-or-nothing type of bet. If the underlying instrument closes above (or below) a specified strike price at expiration, you, the option buyer, will receive $100 per call or put contract accordingly. If not, you’re only out your original investment.

Since binaries are not defined by the Black-Scholes equation, they don’t have “Greeks.” That means, you don’t need to worry about time (theta) decay nor implied volatility. For these reasons, binaries are easy to understand and to trade. (See my 6/30/08 blog for a more in-depth commentary.)

Theoretically, the price of a binary should equal the delta of the associated “regular” option. If it doesn’t, an arbitrage opportunity exists, but unless you’re a floor trader, you probably won’t be able to take advantage of it. Just another card in the deck stacked against the retail trader.

However, one thing that we, the “little people,” can take advantage of is what the binaries are telling us concerning market direction. Binaries are priced between zero and one, and because of their construction, their price at any moment represents how the investing public feels about them succeeding at expiration. Essentially, the current price of a binary option represents the probability that it will expire in the money.

VIX & SPX short-term predictions
The first chart plots VIX put binaries between 20 and 40 for the next three months, July through September. The VIX is currently trading around 30.

The second chart plots the put binaries on the SPX between 850 and 950 for the next three months. The SPX is currently trading near 900. The next support level on the SPX is 875.

[Note that the following charts reflect the average price between the bid and the ask prices. FYI, the charts for the same-strike calls are exactly the opposite.]

The chart of the S&P 500 (SPX) put binaries is telling us that right now the 875 support level is expected to hold with the SPX residing someplace between the 875 and 900 at July expiration.* This movement to slightly lower levels is confirmed by the VIX binary chart. Here, the VIX is expected to move upward, closing between 30 and 32.5 at July expiration.

After July, the situation turns more bullish. The 900 level on the SPX is expected to be reached by mid-August and essentially remain flat to mildly bullish in September. But beware! Just as in meteorology, the uncertainty in long-range forecasting increases. Expansion of the bid/ask spreads in later months reflects this uncertainty especially in the VIX binaries as the September spreads are as high as 20%.

Conclusion
Even after a year of being on the market, the SPX and VIX binaries are thinly traded and, in my opinion, don’t represent a very liquid playing field. However, they still can be a useful tool as a short-term predictor of market direction. As of today, the binaries are forecasting a slight bearish trend in the S&P 500 to mid-July after which it will turn around and stage a mild recovery.

We’ll see if this scenario actually plays out.

*The expiration date for SPX binaries are on the third Friday of each month determined at the market open price. VIX binaries are settled at the opening price of the VIX on the third Wednesday of each month.

Comments

[Tradesmarter:]

Binary options trading is becoming widely popular around the world.
I personally think that as time passes and the liquidity will rise more traders will use binaries for short term swing trades and and as an additional short-term trading tactic.

We in Tradesmarter tried to simplified the trading experience by creating a binary options trading platform.
We ask the trader a simple question, whether a certain instrument will be above or below the last price in an hour or more.

In my opinion, binaries can be a great simplified trading tool for traders for short-term trades rather than trading plain vanilla options.

I'll be glad to invite you to experience Tradesmarter options trading experience and here your feedback about the usage of binaries a mass market trading tool.

Jun 24 07:50 AM

[Maxe Paul:]

Binary betting has been around for nearly ten years now, notably with IG index, and IG markets being the leaders in low spread and binaries on hundreds of markets.

US citizens are not allowed to open an account with spread betters or CFD providers, so it will be new for you (US) guys, but i have been using binaries for 5 years to hedge exposure and bet on index and currency moves.

Personally i love them, and i am still surprised the US has not welcomed them with open arms, particularly given the love affair the US has with leverage and ETF's.

I would recommend anyone interested have a look at IG markets or IG index, you will be quite amazed by the 100's of binary markets.

Most binaries are daily or weekly, so i take it the ones you are referring to are monthly or yearly even?

Jun 24 08:35 AM

[Dave Dorgan:]

I like your idea of using price as a predictor. However, as you say, these are thinly traded and that causes me to have two concerns:
1) Who's behavior - sentiment - are we following here? If thinly traded, then I think that this is the retail side, as Maxe said, "betting". Hence, this is not the smart money.
2) Are these binaries something that the market maker can skew based on demand, much like the Vegas book maker that adjusts the odds to attract equal amounts of money on either outcome?

Jun 24 01:45 PM