Arbitrage is the simultaneous buying and selling of the same security in two different markets with an aim to profit from the price differential. Owing to their unique payoff structure, binary options have gained huge popularity among the traders. We look at the arbitrage opportunities in binary options trading.
A Quick Intro To Arbitrage
Suppose a stock is listed on both the NYSE and NASDAQ stock exchanges. A trader observes that the current price of the stock on the NYSE is $10.1 and that on the NASDAQ it is $10.2. She purchases 10,000 of the lower-priced shares (on the NYSE), costing $101,000 and simultaneously sells the same quantity of 10,000 higher-priced shares, costing $102,000. She manages to pocket the difference (102,000-101,000 = $1000) as profit (assuming there is no brokerage commission).
Effectively, arbitrage is risk-free profit. At the end of the two transactions (if executed successfully), the trader is not holding any stock position (so she is risk-free), yet she has made a profit.
Options trading involves high variations in prices, which offers good arbitrage opportunities. While stocks may need two different markets (exchanges) for arbitrage, option combinations allow arbitrage opportunities on the same exchange. For example, combining a long put and a long futures position results in the creation of a synthetic call, which can be arbitraged against a real call option on the same exchange. Effectively, assets with similar payoffs are arbitraged against each other.
Additionally, other variations in arbitrage exist. A long position in a stock can be arbitraged against a short position in stock futures. Arbitrage opportunities can also be explored between correlated commodities and currencies (examples follow).
While the plain vanilla call and put options offer a linear payoff, binary options are a special category of options that offer “all-or-nothing” or “fixed price” payoffs.
Here is the graphical representation of the difference in payoffs between the two:
The linear (and varying) payoff from plain vanilla options allows for combinations of different options, futures, and stock positions to be arbitraged against each other (and a trader can benefit from the price differentials). The fixed payoff of binary options limits the combination possibilities.
The key idea of arbitrage is simultaneously buying and selling assets of similar profile (synthetic or real) to profit from the price difference. One of the biggest challenge with binary options is that there are hardly any assets that have a similar payoff profile. Trying combinations involving different assets to replicate the binary option payoff function is a cumbersome task. It involves taking multiple positions—something that is very difficult for timely trade execution and costs high brokerage commissions.
Arbitrage Opportunities in Binary Options Trading:
Within the above-mentioned constraints, the arbitrage opportunities in binary option trading are limited. Finding similar assets to simultaneously arbitrage against is difficult. The best available option is to go for time-based arbitrage. It involves identifying a market discrepancy, taking a position accordingly, and then booking the profits after some time when that discrepancy gets eliminated or the price target/stop-losses are hit.
NADEX is the popular exchange for trading binary options. Keep in mind 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 happen when a market is closed may lead to rapid moves in prices when the market opens.
For example, there may be a news item that affects the FTSE 100 stock index and comes out when the London Stock Exchange (LSE) is closed. The exact impact of such news on the FTSE 100 index will be visible only when the LSE opens and the FTSE starts updating. Until then, speculations will be high about 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 available for extended hours, a lot of volatility and price moves as a result of the news may be visible in FTSE binary options.
Suppose the LSE is currently closed and there are no updates to the FTSE index (last closing value was 7000). Assume last price for binary option "FTSE > 7100" was $30. As a result of the developing news, the FTSE is expected to rise once the market opens (say five hours from now), and this binary option value will start to rise (and fluctuate) from the current price of $30 to $50, $60, $70 and so on. Since there is no certainty about what will be the exact FTSE value when it will 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 in the FTSE Index values and FTSE futures prices will be visible. That will lead to FTSE 100 binary options prices to move towards accurately reflecting FTSE 100 values. By that time, experienced traders could have spotted overbought and oversold conditions in the binary options market and made profits (possibly couple of times).
Other binary option arbitrage opportunities come from correlated assets, such as the impact of commodity price changes that lead to currency price changes. Usually, 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 look for arbitrage opportunities in associated forex binary options in such scenarios.
For example, a trader observes that gold prices are rising. He can short sell US dollar by selling the USD/JPY pair or by buying EUR/USD pair. Similarly, an increase in oil prices can lead to an expected increase in the price of EUR/USD. A binary options trader can take appropriate positions to benefit from these changes in asset prices.
Arbitrage in other binary options, such as "non-farm payroll binary options", is difficult because such an underlying is not correlated to anything. One can still attempt time-based arbitrage, but this would be solely on speculation (e.g. take a position as the expiry approaches and attempt to benefit from volatility).
Binary Options: Better 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 is no variability (or linearity) in returns and risks. Buying a binary option at $40 will result in either a $60 profit (final payoff – buy price = $100 - $40 = $60) or a $40 loss. Any impact of news/earnings/other market developments will lead the price to fluctuate (from $40 to $50, $80, $10, $15, and so on).
Arbitrageurs usually don’t wait for binary options to expire. They book the partial profits or cut their losses before. Since binary options have fixed price flat payoffs, any change in the underlying value can have a big impact on returns.
For example, if the FTSE closed at 7000, and the binary option FTSE>7100 was trading at $30, and then positive news about 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 just a one-point difference in the FTSE can make or break the win-loss payout for a trader. If the FTSE ends at 7099, the buyer losses the premium he paid ($30). If the FTSE ends at 7100, he receives a profit of ($100-$30 = $70). This -$30 to +$70 is a huge variation based on a one point limit of the underlying (7099 to 7100), and that leads to very high volatility for binary option valuations, creating huge price swings for active binary option traders to capitalize upon.
The Bottom Line
Standard arbitrage (simultaneous buying and selling of similar security across two markets) may not be available to binary options traders due to a lack of similar 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 also bring in large potential for losses. Due to its high-risk, high-return nature, binary options trading is advisable for experienced traders only.