Defining “Moneyness” In Binary Options

Defining “Moneyness” In Binary Options

When learning about trading binary options, you may have come across the term “Moneyness.”  But what is Moneyness? Basically, it tells traders the current intrinsic value of their binary and whether or not it would be profitable if the binary option was exercised immediately.  It associates the binary’s strike price relative to the binary option’s underlying market price.

Let’s clarify Moneyness further. You may have noticed that there are many strike prices and expiration times available when trading binary options. Essentially, there are three states that pertain to the binary option as to the given strike prices on any binary instrument. These states can change as the market moves up and down relative to the strike.

Note with binary options, there is only one option chain, unlike regular options, where there are calls and puts. For the binary option chain, the quotes are really in terms of the buyer, so with a price range of 0 to 100, the binary buyer wants the price to expire at 100.  Naturally, the binary seller wants the binary price to expire at 0. You may have already come to the conclusion that binary pricing is really all about probabilities of the market’s assessment of finishing in the money.

As a binary buyer, you are expecting that the underlying market price will be above the binary strike level at expiration. However, if you are the binary seller, you are expecting the opposite, in hopes of receiving the settlement payout of \$100 per contract.

The first state is At The Money (ATM)-  This is where the underlying market is currently trading around the strike of the binary.  If you think about it, neither the buyer not the seller of the ATM binary have much of a trade advantage. You know that the settlement payout at expiration is \$100, so naturally both parties (buyer/seller) should have their initial trade cost very close to the same going into the trade.  When the binary is ATM, the pricing should be around \$50, which is half of the settlement payout.

The second state is Out of The Money (OTM)- A binary strike that is OTM would be where the trader is initiating a trade at a disadvantage.  For a binary buyer, an OTM binary would be where the underlying market price is below the strike level.  The greater this differential, the greater the initial trade disadvantage, which reflects a cheaper initial binary cost.  This would be a binary price that is quoted less than 50.

For a binary seller, an OTM binary would be where the underlying market price is above the strike level.  As a seller, you need the underlying to finish below the strike at expiration to finish in the money.  The greater this differential, the greater the seller’s initial trade disadvantage.  The greater the disadvantage, the cheaper the initial cost of the binary.

For the seller, this means that the binary price would be greater than 50.  For the seller, if the binary is priced at 80, the seller is short at the 80 trade price and wants it to expire at 0.  The seller’s risk is to the upside if the binary price trades higher or the maximum risk/cost would be \$20 per contract, a smaller portion out of 100.

To calculate Binary Seller’s Cost:  100 settlement payout – Binary Trade Price

The last state is In The Money (ITM)-  A binary strike that is ITM would be where the trader is initiating a trade at an advantage.  This means the cost for either the buyer or seller is a higher portion out of 100 (greater than \$50.)

For the binary buyer, the underlying is above the strike when initiating the trade.  The underlying is below the strike for the binary seller.

General guidelines:

An OTM binary has a lower probability of expiring in the money.

• Higher risk of failure but less dollars at risk.
• Lower initial cost with higher profit.

An ITM binary has a higher probability of expiring in the money.

• Lower risk of failure but higher dollars at risk.
• Higher initial cost with lower profit.

An ATM binary has around a 50:50 probability of expiring in the money.

• Higher risk of failure but less dollars at risk.
• Lower initial cost with higher profit.