In this article, we will be discussing trading volatility on binary options.

What are binary options?

Binary options or binary betting are essentially a class of exotic trading options, with the payoff having only two possible outcomes. Hence, it derives the name binary options. Binary options can be used to trade within a wide variety of markets such as the stock indices, shares, commodities, Forex, and so on. In addition to these markets, it is also possible to trade measures of variation such as volatility.

What is volatility?

Volatility is essentially a measure of the movement within the prices of the underlying asset. The higher the price movements in the underlying security, the higher its volatility will be. Whereas, securities that trade within a tight range will have a comparatively lower degree of volatility.

There are two types of volatility, these are; historical volatility and implied volatility.

Historical volatility is an indicator of how the price of a particular security has moved in the past, within a specific time frame.

Implied volatility known as the indication of what the market expects the price of that security to do in the future. Implied volatility is normally priced at the value of the option.

How do we trade volatility?

There are quite a few trading strategies that can be used to trade volatility using binary options. The strategy differs depending on whether the underlying security is highly volatile or trades within a range. The commonly used strategies for trading volatility are as follows:

High Volatility: If the trader expects the price of the underlying to be extremely volatile during a given period then he can choose to:

BUY/SELL OTM (out of the money) binary strikes: The benefit of this strategy is that this initial outlay will be much less, compared to the possible payoff. The trader can also choose to create a combination strategy where again both the legs of the strategy would be OTM strikes. The payoff would depend on the price of the underlying at the time of expiry.

For example: A trader who wishes to trade volatility in the USD/JPY pair can choose to buy a USD/JPY>101.50 at 6.50 per contract, whereas, at the same time selling USD/JPY>101 at 84.30. Hence, the initial outlay would be $22.2 (6.50+15.7). Upon expiry, the payoff, if the pair is trading above 101.5 or below 101, would be $77.8. However, if it is trading between those two prices, then the trader suffers a $22.2 loss on the trade.

Low Volatility: If the trader is of the view that the price of the underlying will stay within a trading range, which will result in low volatility; he can choose to:

Trade by buying/selling binaries that are ITM (in the money). Similarly, even a combination trade can be entered into by buying/selling ITM strikes. The advantage of having wide spreads is that it increases the probability of a profit, but it will also increase the initial cost at the same time.

For example: If the trader is of the view that the USD/JPY pair would remain within a trading range; they could choose to purchase USD/JPY> 101 at 84.30 per and Sell USD/JPY>101.50 at 16.50. Their total outlay would be $167.8 (84.30+83.5). The payoff in this situation will be $32.2 if the USD/JPY pair stays between 101 and 101.5. In the event the pair moves above 101.5 or below 101 the trader would incur a loss of $67.8.

Using binary options allows the investor to trade the volatility of the underlying security. However, it imperative to realise that investing involves a large amount of risk to one's capital and may not be right for all investors.