Forex binary options’ valuation – Investment Innovations

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Forex binary options’ valuation - Investment InnovationsAlmost every trader can find a lot of exciting pieces of information about binary options. There are  many  overviews, articles and books about this market as well as many websites promoting binary options.

Be careful! Binary options look very simple but they are designed to be profitable for the brokerage firms not for you. In order to gain from this kind of financial products you must learn the methods of valuation and risk managements.

The binary or digital option is a bet. You can win all pool or loss all money you put on  the table. For example you can put $20 for the EURUSD be over 1.3 tomorrow at 4 pm. If you win you receive $60. You  may also lose your $20 if EURUSD stops below the barrier of 1.3000. Such bet is called a digital option with stake $60 and price  20/60 = 0.333. In other words if you multiply a price by a stake, you obtain an amount you must put on the table (ie. money you risk).

You can also sell this digital option. Lets assume that you sell it at a price of  0.31. If the stake will be for instance $100, you receive instantly 0.31*100=$31. You can do whatever you want with this additional amount of money until the day of expiration (tomorrow in our example). If the EURUSD is below 1.3 on expiration you win and you can save your $30 forever but if you lose you must pay $100. This means that you lost $70 (100-30).

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The prices of digital options are always the numbers from the range from 0 to 1 (inclusively). If an event linked to the option occurs on expiration time the value is 1, otherwise the value of the option is 0. The broker always give you two prices: Bid and Ask. You can buy an option at Ask price or sell it to the broker at Bid price. Of course Bid is less than Ask.

How to find the value of the option? The idea is based on Monte Carlo method. The Option Evaluator simulates 1000′s  of various of possible quotes’ trajectories and calculate the final option’s value for each trajectory. This huge set of data is used for fair price estimation. If your broker offers you better prices than indicated the program  you may try to buy/sell option because the probability supports you not a broker. This doesn’t mean that you surely win but only the fact that expected value of the trade is greater than zero.

Valuation of all common types of options: binary (above-below), binary range, binary up-down and vanilla options PUT and CALL

User can download latest 1-hour quotations (from last 360 days) of all currency pairs with one click

I call the price fair if it equals probability of the event. For example if probability of  tomorrow’s EURUSD quote will be higher than 1.4 is 0.05 the price for the options should be 0.05. This means that for each $5 you spent for the option, you should get $100 if  you win. My Option Evaluator simply calculates fair prices of options. It is rather rare event when the broker gives you better prices than fair ones. But it happens because brokers use simplified mathematical models based on Black-Scholes formula or, generally saying, they use models based on assumption of normal-distribution of  changes of prices. These models are criticized because they ignore something like trends or temporary asymmetry of investors’ preferences. The temporary asymmetry is the factor which we may use to beat the broker. In order to measure and detect the asymmetries (deviations from normal-distribution) the program uses 1000′s of numerical simulations of currency pair quotations. This allows us to obtain reliable probabilities and expected values of returns needed to estimate fair price of digital options.

Take a look at the screenshot below. You can see there the fair prices of  above-below option. Notice that fair price is also a probability of an event.  Fair gain is a minimum earning (with given stake) you should get, when investing (buy or sell) in the option. If your broker offers less gain don’t invest. In our example we can see that we can buy “below option” at maximum price 0.8239 or sell this option at price 0.1761.

The program performs simulations based on historical data. But these are not simple procedures used by brokers, banks and many financial institutions. As a trader you know very well that financial institutions are not as smart as majority thinks. They fail many times and many times they are saved by governments. The Option Evaluator performs simulations not for… Read more…

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