Arbitrage is defined as the simultaneous purchase and sale of the identical securities in two distinct marketplaces in order to benefit from the price difference. Binary options have grown in popularity among traders due to its unique payment structure. In this article, we will look at the arbitrage potential in binary options trading.
A Quick Intro to Arbitrage
Assume a stock is traded on both the NYSE and the NASDAQ. A trader notices that the stock is now trading at $10.10 on the NYSE and $10.20 on the NASDAQ. They buy 10,000 lower-priced shares (on the NYSE) for $101,000 and concurrently sell the same number of higher-priced shares for $102,000. They are able to benefit from the differential (102,000-101,000 = $1000). (assuming there is no brokerage commission).
Arbitrage is effectively risk-free profit. The trader is not holding any stock positions at the conclusion of the two transactions (so they are risk-free), yet they have earned a profit.
Price fluctuations in options trading are large, which provides strong arbitrage possibilities. While stocks may need two separate markets (exchanges) for arbitrage, option combinations allow for arbitrage on the same exchange. Combining a long put with a long futures position, for example, yields an asynthetic call that may be arbitraged against a genuine call option on the same exchange. Assets with comparable payoffs are effectively arbitraged against one other.
There are many more arbitrage versions. A stock long position may be arbitraged against a stock futures short position. Arbitrage possibilities between linked commodities and currencies may also be investigated (examples follow).
While traditional call and put options have a linear payout, binary options are a subset of options that have “all-or-nothing” or “fixed price” payoffs.
Here is a graphical illustration of the payout differences between the two:
Because simple vanilla options have a linear (and changing) payout, they may be arbitraged against other options, futures, and stock holdings (and a trader can benefit from the price differentials).Binary options’ fixed payment restricts the combination possibilities.
The basic concept of arbitrage is to acquire and sell assets of comparable profile (synthetic or real) at the same time in order to benefit from the price difference. One of the most difficult aspects of binary options is that there are few assets with identical reward profiles. Trying alternative asset combinations to reproduce the binary option payout function is a time-consuming job. It entails taking many positions, which is challenging for quick trade execution and incurs large brokerage charges.
Arbitrage Opportunities in Binary Options Trading
Arbitrage prospects in binary option trading are restricted due to the aforementioned limits. Finding equivalent assets to arbitrage against at the same time is tough. Time-based arbitrage is the best accessible solution. It entails spotting a market disparity, entering a position, and then registering gains when the gap is erased or the price target/stop-losses are met.
NADEX is a well-known binary options exchange. Keep in mind that other stock, index, futures, options, and commodity markets have distinct (and restricted) trading hours. Depending on the exchange-enabled trading hours, many assets (stocks, futures, and options) trade at various times of the day. When a market is closed, developments might cause significant price movements when the market reopens.
For example, a news item affecting the FTSE 100 stock index may be released while the London Stock Exchange (LSE) is closed. The full effect of such news on the FTSE 100 index will be apparent only when the LSE opens and the FTSE begins to update. Until then, there will be much discussion regarding the perceived effect of the news on the FTSE’s valuation.
This index serves as the benchmark for binary options trading on NADEX. Because binary options trading is accessible 24 hours a day, there may be a lot of volatility and price movements as a consequence of news in FTSE binary options.
Assume the LSE is now closed and the FTSE index has not been updated (last closing value was 7000).Assume the most recent price for the binary option “FTSE > 7100” was $30. As a consequence of the breaking news, the FTSE is projected to climb once the market opens (say, five hours from now), and the value of this binary option will begin to rise (and vary) from $30 to $50, $60, $70, and so on. Because there is no way of knowing what the actual FTSE value will be when it opens for trade, binary option prices will vary up and down. During this period, skilled traders may profit from time-based arbitrage by betting on FTSE binary options.
The real change in the FTSE Index values and FTSE futures prices will be seen once the market starts. As a result, FTSE 100 binary options pricing will begin to more precisely represent FTSE 100 values. By then, experienced traders might have identified overbought and oversold positions in the binary options market and profited from them (possibly couple of times).
Other potential for binary option arbitrage emerge from linked assets, such as the influence of commodities price movements on currency prices. Gold and oil often have an inverse relationship with the US dollar (i.e., if gold or oil prices rise, then USD currency weakens and vice versa).In such cases, experienced traders might hunt for arbitrage possibilities in connected forex binary options.
A trader, for example, notices that gold prices are increasing. They may sell the US dollar short by selling the USD/JPY pair or purchasing the EUR/USD pair. Similarly, a rise in oil prices may be anticipated to contribute to an increase in the EUR/USD pricing. A binary options trader may profit from fluctuations in asset values by taking proper positions.
Other binary options, such as “non-farm payroll binary options,” are difficult to arbitrage since the underlying is unrelated to anything. Time-based arbitrage may still be attempted, but only on assumption (e.g. take a position as the expiry approaches and attempt to benefit from volatility).
Binary Options: Better for Arbitrage?
Arbitrageurs benefit from high volatility. Binary options provide a “all-or-nothing” or “fixed price” profit and loss of $100. Returns and risks have no fluctuation (or linearity) like simple vanilla options. Purchasing a binary option for $40 results in a $60 profit (final payment – purchase price = $100 – $40 = $60) or a $40 loss. The price will change due to the influence of news/earnings/other market movements (from $40 to $50, $80, $10, $15, and so on).
Arbitrageurs do not often wait for binary options to expire. They have already booked some gains or lowered their losses. Because binary options offer set payoffs, any change in the underlying value may have a significant influence on returns.
For example, if the FTSE finished at 7000 and the binary option FTSE>7100 was trading at $30, and then the FTSE received favorable news. The FTSE index hits 7095 and remains within a 10-point range of that level (7095-7105).The binary option price will fluctuate dramatically, since a one-point change in the FTSE may make or break a trader’s win-loss payment. If the FTSE finishes at 7099, the buyer loses the $30 premium he paid. If the FTSE finishes at 7100, they profit ($100-$30 = $70). This -$30 to +$70 range is predicated on a one-point limit of the underlying (7099 to 7100), resulting in exceptionally high volatility for binary option valuations and large price swings for active binary option traders to profit from.
The Bottom Line
Due to a lack of identical assets trading across several markets, standard arbitrage (simultaneous buying and selling of similar securities across two markets) may not be possible to binary options traders. Arbitrage possibilities in binary options should be sought for during off-market hours in connected markets or correlated assets. Binary options’ distinctive “all-or-nothing” payment structure allows for time-based arbitrage possibilities. Significant variances provide for high profit potential but also a high risk of loss. Binary options trading is only recommended for experienced traders due to its high-risk, high-reward nature.
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