Arbitrage is the simultaneous buying and selling of the identical security in two different markets with an aim to take advantage of the worth differential. Owing to their unique payoff structure, binary options have gained huge popularity among the many traders. We have a look at the arbitrage opportunities in binary options trading.

A Quick Intro to Arbitrage

Suppose a stock is listed on each the NYSE and NASDAQ stock exchanges. A trader observes that the present price of the stock on the NYSE is $10.10 and that on the NASDAQ it’s $10.20. They purchase 10,000 of the lower-priced shares (on the NYSE), costing $101,000 and concurrently sell the same amount of 10,000 higher-priced shares, costing $102,000. They manage to pocket the difference (102,000-101,000 = $1000) as profit (assuming there isn’t any brokerage commission).

Effectively, arbitrage is risk-free profit. At the tip of the 2 transactions (if executed successfully), the trader will not be holding any stock position (in order that they are risk-free), yet they’ve made a profit.

Options Arbitrage

Options trading involves high variations in prices, which offers good arbitrage opportunities. While stocks might have two different markets (exchanges) for arbitrage, option combos allow arbitrage opportunities on the identical exchange. For instance, combining an extended put and an extended futures position leads to the creation of a synthetic call, which will be arbitraged against an actual call option on the identical exchange. Effectively, assets with similar payoffs are arbitraged against one another.

Moreover, other variations in arbitrage exist. A protracted position in a stock will be arbitraged against a brief position in stock futures. Arbitrage opportunities may also be explored between correlated commodities and currencies (examples follow).

Binary Options

While the plain vanilla call and put options offer a linear payoff, binary options are a special category of options that provide “all-or-nothing” or “fixed price” payoffs.

Here is the graphical representation of the difference in payoffs between the 2:

The linear (and ranging) payoff from plain vanilla options allows for combos of various options, futures, and stock positions to be arbitraged against one another (and a trader can profit from the worth differentials). The fixed payoff of binary options limits the mix possibilities.

The important thing idea of arbitrage is concurrently buying and selling assets of comparable profile (synthetic or real) to take advantage of the worth difference. Certainly one of the largest challenge with binary options is that there are hardly any assets which have an identical payoff profile. Trying combos involving different assets to copy the binary option payoff function is a cumbersome task. It involves taking multiple positions—something that could be very difficult for timely trade execution and costs high brokerage commissions.  

Arbitrage Opportunities in Binary Options Trading

Throughout the above-mentioned constraints, the arbitrage opportunities in binary option trading are limited. Finding similar assets to concurrently arbitrage against is difficult. One of the best available option is to go for time-based arbitrage. It involves identifying a market discrepancy, taking a position accordingly, after which booking the profits after a while when that discrepancy gets eliminated or the worth goal/stop-losses are hit.

NADEX is a preferred exchange for trading binary options. Consider that other markets for stocks, indices, futures, options, or commodities have different (and limited) trading hours. Multiple assets (stocks, futures, options) trade at different times of the day depending upon the exchange-enabled trading hours. Developments that occur when a market is closed may result in rapid moves in prices when the market opens.

For instance, there could also be a news item that affects the FTSE 100 stock index and comes out when the London Stock Exchange (LSE) is closed. The precise impact of such news on the FTSE 100 index can be visible only when the LSE opens and the FTSE starts updating. Until then, speculations can be high concerning the perceived impact of the news on the FTSE’s value.

This index is the benchmark for trading binary options on NADEX. Since binary options trading is accessible for prolonged hours, a whole lot of volatility and price moves because of this of the news could also be visible in FTSE binary options.

Suppose the LSE is currently closed and there aren’t any updates to the FTSE index (last closing value was 7000). Assume last price for binary option “FTSE > 7100” was $30. In consequence of the developing news, the FTSE is predicted to rise once the market opens (say five hours from now), and this binary option value will begin to rise (and fluctuate) from the present price of $30 to $50, $60, $70 and so forth. Since there isn’t any certainty about what can be the precise FTSE value when it’s going to open for trading, the binary option prices will fluctuate up and down. During this time, experienced traders can bet their money on FTSE binary options for time-based arbitrage. 

Once the market opens, the actual change within the FTSE Index values and FTSE futures prices can be visible. That may result in FTSE 100 binary options prices to maneuver towards accurately reflecting FTSE 100 values. By that point, experienced traders could have spotted overbought and oversold conditions within the binary options market and made profits (possibly couple of times).

Other binary option arbitrage opportunities come from correlated assets, reminiscent of the impact of commodity price changes that result in currency price changes. Normally, gold and oil have an inverse correlation with the US dollar (i.e., if gold or oil prices rise, then USD currency weakens and vice versa). Experienced traders can search for arbitrage opportunities in associated forex binary options in such scenarios.

For instance, a trader observes that gold prices are rising. They’ll short sell US dollar by selling the USD/JPY pair or by buying EUR/USD pair. Similarly, a rise in oil prices can result in an expected increase in the worth of EUR/USD. A binary options trader can take appropriate positions to profit from these changes in asset prices.

Arbitrage in other binary options, reminiscent of “non-farm payroll binary options”, is difficult because such an underlying will not be correlated to anything. One can still attempt time-based arbitrage, but this is able to be solely on speculation (e.g. take a position because the expiry approaches and try to profit from volatility).   

Binary Options: Higher for Arbitrage?

High volatility is a friend of arbitrageurs. Binary options offer “all-or-nothing” or “fixed price” profit ($100) and loss ($0). Like plain vanilla options, there isn’t any variability (or linearity) in returns and risks. Buying a binary option at $40 will lead to either a $60 profit (final payoff – buy price = $100 – $40 = $60) or a $40 loss. Any impact of reports/earnings/other market developments will lead the worth to fluctuate (from $40 to $50, $80, $10, $15, and so forth). 

Arbitrageurs often don’t wait for binary options to run out. They book the partial profits or cut their losses before. Since binary options have fixed price flat payoffs, any change within the underlying value can have a huge impact on returns.

For instance, if the FTSE closed at 7000, and the binary option FTSE>7100 was trading at $30, after which positive news concerning the FTSE comes out. The FTSE reaches 7095 and is hovering around that level in a 10-point range (7095-7105). The binary option price will show huge variations, as only a one-point difference within the FTSE could make or break the win-loss payout for a trader. If the FTSE ends at 7099, the customer losses the premium he paid ($30). If the FTSE ends at 7100, they receive a profit of ($100-$30 = $70). This -$30 to +$70 is a big variation based on a one point limit of the underlying (7099 to 7100), and that results in very high volatility for binary option valuations, creating huge price swings for energetic binary option traders to capitalize upon.

The Bottom Line

Standard arbitrage (simultaneous buying and selling of comparable security across two markets) will not be available to binary options traders because of an absence of comparable assets trading across multiple markets. Arbitrage opportunities in binary options are to be picked from those available during off-market hours in associated markets or correlated assets. The unique “all-or-nothing” payoff structure of binary options allow for time-based arbitrage opportunities. High variations enable high profit potentials, but additionally herald large potential for losses. Resulting from its high-risk, high-return nature, binary options trading is advisable for skilled traders only.