Binary Option Behavior as Expiration Approaches
With regular put/call options, as expiration approaches, the time value goes down. This is known as time decay. With binary options, as expiration approaches, you will start to notice a very interesting phenomenon. This phenomenon occurs due to the binary nature of these options. It also presents some interesting opportunities and should be addressed, as it is a key attribute of binary options.
In order to illustrate this phenomenon, you must understand the concept of delta. Delta is simply the amount that the price of the option changes for every dollar that the price of the underlying changes. For example, with a deep-in-the-money option, the delta will be 1 to 1 since for every dollar that the underlying grows, the option will also grow by $1.
If you have a deeply out-of-the-money option, the option will have a lower delta. This is due to the fact that as the underlying grows by $1, the option does not become significantly more likely to be in-the-money. Therefore, the $1 growth in the underlying will have only a minimal impact on the price of the option.
As you will shortly see, the delta will behave significantly differently with vanilla put/call options than with binary options.
To learn more about delta and other option parameters, you can visit our companion site, www.traderschoiceu.com.
In Exhibit 9.1 a profit-and-loss (P&L) graph of a long binary option is juxtaposed with a P&L graph of a vanilla ...