The NCAA® tourney started yesterday and March Madness is in full swing. 64 teams began yesterday with dreams of winning 6 consecutive games to become National Champion. As traders, we are always looking for trading set ups and analyzing probabilities of success. Because the NCAA tourney is a single elimination tournament, that means that each team must win 6 consecutive games. If you’ve ever watched the tournament before then you are well aware of the vast amount of upsets that are unavoidable. Even when there is a high probability of success you must be aware that losses will be incurred, and this applies to trading as well.
What if I told you that last year’s National Champion Villanova, which happens to be my alma mater (everyone saw that final shot last year, right?), has an 88% chance of winning each game they play in this year’s tourney. What would you say their chances would be of repeating as national champions with an 88% chance of winning each game? Well, surprisingly, even if Villanova had an 88% chance of winning each game they would actually be an underdog to repeat with only a 46.44% chance of success of 6 consecutive wins. (0.88*0.88*0.88*0.88*0.88*0.88=46.44%).
When trading binary options you are constantly forced to analyze the risk vs. reward of a trade compared to the perceived probability of success. If you are risking $80 to make $20 then you should believe there is at least an 80% chance that your binary option expires in the money if you plan to hold it until expiration.
Here is a chart of the Crude Oil chart at about 7:52 a.m. ET this morning, which is based off the indicative Index that is the April NYMEX® Futures price. Along the right axis are some of the daily binary options available on the NADEX exchange, which expire at 2:30 p.m. ET today, leaving about 6.5 hours until expiration.
If you bought the >$48.50 binary option for $80 then you would be risking that $80 for a maximum profit of $20 if the contract expired in-the-money for full value of $100. Crude Oil is currently trading $0.46 above the $48.50 strike price, which is why you will be risking $4 for every potential $1 in profit for this trade. What if you planned on making 6 trades every day, with each trade having an 80% chance of success? What would the probability be on any given day that you are profitable on all 6 trades if they each had an 80% chance of success? The answer is 26.21%. (0.80*0.80*0.80*0.80*0.80*0.80=26.24%). This applies to longs and shorts, regardless of your market expectation. If you’re a trader that plans on making high probability trades where you’re risking $4 for every $1 of potential profit then you should be aware of the very real possibility that losses will be incurred on a regular basis, just as upsets are all but guaranteed in the NCAA tourney.
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