Using binary options to forecast market direction

Binary options have been around for a couple of years. There are binary options on some of the more highly traded stocks and ETFs such as Apple, Microsoft, and QQQQ. These are offered on the AMEX, but so far there are only two binaries offered on the CBOE—the SPX, the S&P 500 index, and the VIX, the volatility index.

What are binary options?
Binary options are an all-or-nothing type of bet. If the underlying instrument closes above (or below) a specified strike price at expiration, you, the option buyer, will receive $100 per call or put contract accordingly. If not, you’re only out your original investment.

Since binaries are not defined by the Black-Scholes equation, they don’t have “Greeks.” That means, you don’t need to worry about time (theta) decay nor implied volatility. For these reasons, binaries are easy to understand and to trade. (See my 6/30/08 blog for a more in-depth commentary.)

Theoretically, the price of a binary should equal the delta of the associated “regular” option. If it doesn’t, an arbitrage opportunity exists, but unless you’re a floor trader, you probably won’t be able to take advantage of it. Just another card in the deck stacked against the retail trader.

However, one thing that we, the “little people,” can take advantage of is what the binaries are telling us concerning market direction. Binaries are priced between zero and one, and because of their construction, their price at any moment represents how the investing public feels about them succeeding at expiration. Essentially, the current price of a binary option represents the probability that it will expire in the money.

VIX & SPX short-term predictions
The first chart plots VIX put binaries between 20 and 40 for the next three months, July through September. The VIX is currently trading around 30.

The second chart plots the put binaries on the SPX between 850 and 950 for the next three months. The SPX is currently trading near 900. The next support level on the SPX is 875.

[Note that the following charts reflect the average price between the bid and the ask prices. FYI, the charts for the same-strike calls are exactly the opposite.]



The chart of the S&P 500 (SPX) put binaries is telling us that right now the 875 support level is expected to hold with the SPX residing someplace between the 875 and 900 at July expiration.* This movement to slightly lower levels is confirmed by the VIX binary chart. Here, the VIX is expected to move upward, closing between 30 and 32.5 at July expiration.

After July, the situation turns more bullish. The 900 level on the SPX is expected to be reached by mid-August and essentially remain flat to mildly bullish in September. But beware! Just as in meteorology, the uncertainty in long-range forecasting increases. Expansion of the bid/ask spreads in later months reflects this uncertainty especially in the VIX binaries as the September spreads are as high as 20%.

Even after a year of being on the market, the SPX and VIX binaries are thinly traded and, in my opinion, don’t represent a very liquid playing field. However, they still can be a useful tool as a short-term predictor of market direction. As of today, the binaries are forecasting a slight bearish trend in the S&P 500 to mid-July after which it will turn around and stage a mild recovery.

We’ll see if this scenario actually plays out.

*The expiration date for SPX binaries are on the third Friday of each month determined at the market open price. VIX binaries are settled at the opening price of the VIX on the third Wednesday of each month.

For the record:  The Stock Market Cook Book would like to wish website designer and occasional article contributor, Professor Pat, a very HAPPY BIRTHDAY!

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