Arbitrage is the simultaneous buying and selling of the same security in two different markets, with the purpose of profiting from price differences. Due to its unique income structure, binary options are very popular among traders. We look at arbitrage opportunities in binary options trading.
A quick introduction to arbitrage
Suppose a stock is listed on the New York Stock Exchange and the Nasdaq Stock Exchange. A trader observed that the current price of the stock on the New York Stock Exchange is $10.10, while the current price on the Nasdaq is $10.20. They bought 10,000 lower-priced stocks (on the New York Stock Exchange) for $101,000 and sold the same number of 10,000 higher-priced stocks at a cost of $102,000. They managed to pocket the difference (102,000-101,000 = 1,000 USD) as a profit (assuming there is no brokerage commission).
In fact, arbitrage is risk-free profit. At the end of the two trades (if executed successfully), the traders did not hold any stock positions (so they are risk-free), but they have made a profit.
Options trading involves high price volatility, which provides good arbitrage opportunities. Although stocks may require arbitrage on two different markets (exchanges), a combination of options allows arbitrage opportunities on the same exchange. For example, combining long put options and long futures positions will produce synthetic call options, which can be arbitrage for actual call options on the same exchange. In fact, assets with similar returns are mutually arbitrage.
In addition, there are other arbitrage changes. Long positions in stocks can arbitrage short positions in stock futures. You can also explore arbitrage opportunities between related commodities and currencies (examples are below).
Although ordinary call options and put options provide linear returns, binary options are a special category of options that provide “all or nothing” or “fixed price” returns.
This is a graphical representation of the difference in revenue between the two:
The linear (and variable) returns of ordinary options allow combinations of different options, futures, and stock positions to profit from each other (traders can benefit from price differences). The fixed income of binary options limits the possibility of combination.
The key idea of arbitrage is to buy and sell assets with similar characteristics (synthetic or real) at the same time to profit from price differences. One of the biggest challenges of binary options is that almost no asset has similar return characteristics. Trying to replicate the binary option return function involving a combination of different assets is a tedious task. It involves holding multiple positions-which is very difficult for timely execution of trades and requires high brokerage commissions.
Arbitrage opportunities in binary options trading
Under the above constraints, arbitrage opportunities for binary options trading are limited. It is difficult to find similar assets and carry out arbitrage at the same time. The best option is to conduct time-based arbitrage. It involves identifying market discrepancies, establishing positions accordingly, and then booking profits after the discrepancies are eliminated or the price target/stop loss is touched for a period of time.
NADEX is a popular binary options trading exchange. Keep in mind that other stock, index, futures, options or commodity markets have different (and limited) trading hours. Multiple assets (stocks, futures, options) are traded at different times of the day, depending on the trading hours of the exchange. Developments that occur when the market is closed may cause rapid price fluctuations when the market opens.
For example, there may be a piece of news that affects the FTSE 100 stock index and is released when the London Stock Exchange (LSE) is closed. The exact impact of such news on the FTSE 100 index will only become apparent when the London Stock Exchange opens and the FTSE index starts to update. Before that, people would highly speculate on the impact of the news on the value of the FTSE Index.
This index is the benchmark for trading binary options on NADEX. Due to the extended trading hours of binary options, FTSE binary options may see a large amount of volatility and price changes due to news.
Assume that the LSE is currently closed and the FTSE index is not updated (the last closing value is 7000). Assume that the final price of the binary option “FTSE> 7100” is $30. Due to the development of news, it is expected that once the market opens (for example, five hours from now) the FTSE index will rise, and the value of this binary option will begin to rise (and fluctuate) from the current price of $30 to $50, 60 US dollars, 70 dollars and so on. Since it is uncertain when the exact FTSE value will be opened for trading, the price of binary options will fluctuate up and down. During this period, experienced traders can stake their funds on FTSE binary options for time-based arbitrage.
Once the market opens, actual changes in FTSE index values and FTSE futures prices will be visible. This will cause the FTSE 100 binary option price to develop in a direction that accurately reflects the FTSE 100 value. By then, experienced traders may have discovered overbought and oversold conditions in the binary options market and made profits (possibly several times).
Other binary options arbitrage opportunities come from related assets, such as the impact of changes in commodity prices that lead to changes in currency prices. Generally, gold and oil are negatively correlated with the US dollar (that is, if the price of gold or oil rises, the US dollar currency depreciates, and vice versa). In this case, experienced traders can look for arbitrage opportunities in related foreign exchange binary options.
For example, a trader observes that the price of gold is rising. They can short the U.S. dollar by selling the USD/JPY pair or buying the EUR/USD pair. Likewise, rising oil prices may lead to an expected increase in the price of EUR/USD. Binary options traders can take appropriate positions to benefit from these changes in asset prices.
The arbitrage of other binary options, such as “non-agricultural wage binary options”, is very difficult, because such an underlying object is not related to anything. One can still try time-based arbitrage, but it will be based entirely on speculation (for example, establishing a position when the expiry date approaches and trying to benefit from volatility).
Binary options: more suitable for arbitrage?
High volatility is the friend of arbitrageurs. Binary options provide “all or nothing” or “fixed price” profit ($100) and loss ($0). Like ordinary options, there is no variability (or linearity) in return and risk. Buying a binary option at 40 USD will result in a profit of 60 USD (final gain-purchase price = 100 USD-40 USD = 60 USD) or a loss of 40 USD. Any impact of news/earnings/other market developments will cause price fluctuations (from 40 USD to 50 USD, 80 USD, 10 USD, 15 USD, etc.).
Arbitrageurs usually do not wait for the expiration of binary options. They booked part of the profits in advance or reduced their losses. Since the income of binary options is fixed, any change in the value of the underlying will have a significant impact on the return.
For example, if the FTSE index closes at 7000 and the trading price of binary options FTSE>7100 is $30, then good news about the FTSE index will come out. The FTSE Index reached 7095 and hovered around this level in the range of 10 points (7095-7105). The price of binary options will show huge changes because only one point difference in the FTSE can determine the trader’s profit and loss expenditure. If the FTSE closes at 7099, the buyer will lose the premium he paid ($30). If the FTSE Index closes at 7100, they will make a profit of ($100-$30 = $70). This -$30 to +$70 is a huge change based on the one-point limit (7099 to 7100) of the subject matter, which leads to very high volatility in the valuation of binary options, creating huge prices for active binary options traders Fluctuate for use.
Due to the lack of similar asset transactions across multiple markets, binary options traders may not be able to use standard arbitrage (simultaneous buying and selling of similar securities in two markets). Arbitrage opportunities for binary options will be selected from the opportunities available in the relevant market or over-the-counter trading hours of the relevant asset. The unique “all or nothing” income structure of binary options allows time-based arbitrage opportunities. High change brings high profit potential, but also huge loss potential. Due to its high risk and high return nature, binary options trading is only suitable for experienced traders.