Improve Your Binary Trading with Implied Volatility Pivots
Bob Iaccino / Co-founder of Path Trading Partners
One of the most ignored facts about binary options is that they are, in fact, options. Price will move based off of implied volatility, price changes in the underlying and the option Greeks, same as classic exchange traded options. Based on that, it behooves the budding binary options trader to learn what they can about option basics and have a general understanding of the moving parts mentioned above. In this article we’d like to cover something very valuable to the short-term binary options trader- using implied volatility to predict expected ranges in an underlying index.
First, what is volatility as it applies to markets? From Investopedia: Volatility is a statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility reading is, the riskier the security.
The more important passage in the definition: 2. A variable in option pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option's expiration. Volatility, as expressed as a percentage coefficient within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value of the coefficient used.
In simple terms, volatility (“vol”) measures the level of uncertainty the market has about a coming price move in an index (or any other underlying). The higher the vol, the larger the expected price moves. The lower the vol, the smaller the expected price moves. It follows that “implied volatility” (“IV”) is an estimate of a particular index’s current real vol.
So why does IV matter? Because it is how options are priced by market makers and helps gauge how they are valued by traders. For example, you may looking to buy a binary option that is 10 points out of the money with 2 hours to expiration on Monday and you are risking $25 to make $75. The very next day you look at another long binary opportunity with the exact same parameters, but this time you would need to risk $45 to make $55. Why is Tuesday more expensive than Monday for the same trade? It is likely due to rising implied volatility. The market now thinks there is risk of a wider range in the price of the underlying and the added risk is represented by higher options pricing.
As a trader your brain should already be thinking, “Well if market makers can comfortably predict the expected range for a day, can’t I use IV to do the same and place trades based on those ranges?” The answer is yes. There are complicated methods and also quick and dirty methods to get the anticipated day’s range. We call price levels derived from implied volatility “IV Pivots”. We utilize a proprietary formula to extract the Implied Volatility from the underlying’s Calls and Puts and convert it to a Daily Implied Volatility. Utilizing these Implied Volatility levels, we then derive the IV Pivots using key standard deviation levels and their associated probabilities to determine key areas and the probabilities that price action will remain above or below those levels. With this formula we can apply a percentage likelihood to different price levels.
For example on March 1st, the April WTI Crude oil contract (“CLJ”) had a very quiet day. It traded in a $0.81 range from high to low and closed down -.06% from the previous day on very low volume. IV was lower for the day. The next day however, CLJ close down -2% on better than recent volume and had a range of $1.26. Our IV pivots gave us the following table for the second:
The percentages in the table above list the probability (based on IV), that the range of CLJ for the day would be between the red levels and the green levels. In simpler terms, there was a 68% chance that the high and low would be between $55.35 and $52.31. The high for the day was $53.80, the low was $52.54 and the close was $52.56. Many traders may have been panicking to get in on the sell side, but as our 50% level was breached, we knew the probability for support to hold was increasing. If you know where daily IV support is, you can bottom fish by purchasing binary options or spreads near the 68% and 80% pivots. You can also sell binary options or spreads above the 50% resistance pivot knowing as time winds down, that it will be harder and harder for the price to break above it.
For example, on March 2nd, the April Gold contract (“GCJ”) was sharply down nearly 1.25%. Going into Friday, March 3th our IV Pivots gave us the following levels for the third:
The percentages in the table above list the probability (based on IV), that the range of GCJ for the day would be between the red levels and the green levels. In simpler terms, there was a 68% chance that the high and low would be between $1242.15 and $1239.14. The high for the day was $1236.70, the low was $1223 and the close was $1235. Many traders may have been panicking to get in on the sell side, but as our 50% level was breached, we knew the probability for support to hold was increasing. If you know where the daily IV support is, you can bottom fish by purchasing binary options or spreads near the 68% and 80% pivots. You can also sell binary options or spreads above the 50% resistance pivot knowing as time winds down, that it will be harder and harder for the price to break above it.
These are just 2 quick suggestions of how to trade IV derived levels, but keep in mind, IV pivots do not predict direction. They only tell you the expected bounds of the day’s range, based on options pricing and volatility. There are many ways to incorporate volatility into your current trading but one thing is certain; whatever method you choose to calculate IV, it’s worth doing. Especially in the context of target-based, limited-risk Nadex binary options and spreads. When a market is moving rapidly in a direction, it sure is nice to know where the market makers think price may stop.
Nadex Risk Disclaimer
· Trading on Nadex involves financial risk and may not be appropriate for all investors. The information presented here is for information and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Any trading decisions that you make are solely your responsibility. Past performance is not indicative of future results. Nadex instruments include forex, stock indexes, commodity futures, and economic events.
· Nadex binary options and spreads can be volatile and investors risk losing their investment on any given transaction. However, the limited-risk nature of Nadex contracts ensures investors cannot lose more than the cost to enter the transaction. Nadex is subject to U.S. regulatory oversight by the CFTC.