Volatility is a measure of how much the price or value of an asset will change during a period of time. A market whose price stays the same for a long time is experiencing low volatility. A market whose price moves up and down, particularly in large moves, is considered more volatile.
The price of an option, binary option, or option spread is strongly affected by the volatility of the underlying market. If the underlying is highly volatile, the option’s value tends to be higher. Flat markets, or markets with low volatility, are associated with lower binary option prices.
How does volatility affect the price of an option or binary option?
Consider a simple example of a binary option one hour before expiration. Let’s say you bought a binary option in gold, with a strike price of $1200. The underlying gold futures market is currently trading at $1190. That means your long binary option position is still out of the money.
The market would need to come up another ten dollars for your binary options to be at the money and be above $1200 at expiration for you to get the full $100 payout. How likely is that to happen?
The probability of that binary option expiring in the money depends on the volatility of the gold market. Imagine that gold has been trading in a small range all day, between 1188 and 1194. Of course, there’s a chance that the market will break out to the upside and rally above 1200 in the next hour. But most of the market participants won’t see that as a high probability, because the market simply hasn’t behaved that way all day. It’s considered a flat market.
In contrast, imagine if gold had been having a wild, volatile trading day, with prices swinging from 1180 all the way to 1220 and back. If gold has done this a few times already today, that means that the market participants are already mentally prepared for it to go above 1200 yet again. After all, it was just there within the last few hours and prices have been moving up and down quickly. That makes the probability higher.
A volatile market appears to have (and may actually have) a higher probability of reaching a larger number of different price levels within a given period of time. A flat market, on the other hand, seems likely to stay where it is. So if your binary option has a strike price other than the price where the market currently is, then the option value depends in part on the probability of the market reaching your strike price.
Since a binary option on a volatile underlying market has a higher probability of expiring in the money, it is more valuable to traders. That’s what gives the option a higher price. The component of the option’s price which can be attributed to volatility is part of the option’s extrinsic value.