Hey ZetArmy, we’re back with some more knowledge to share. We’ve been interested in the world of binary options for a long time, and are thrilled to be building a platform which allows investors to express their opinion through these products.
As always, we want to educate and grow the Zeta community, and have produced a summary of what we think beginner traders need to know about binary markets. If you’re keen on understanding how to think about risk, stay ahead of the market and trade a product that’s existed for over 500 years — keep reading.
What are binary options?
Binary options are tradeable options contracts, pegged to the price of an underlying product, which settle to 0 or a pre-specified fixed payout at expiry (usually 1), depending on if the option is above or below a certain price (i.e. in the money or out of the money). An intuitive way to think of these contracts would be as a bet on whether the asset will finish above (or below) a certain price — you will get paid the pre-agreed payout if you are correct, or lose your initial investment if you are wrong.
Binary option prices should fundamentally reflect opinions investors have on the probability that an asset will finish above (or below) a certain strike.
These contracts naturally trade as probabilities. What this means is that the prices of these contracts are reflective of the chances of events occurring — this can be demonstrated by calculating the expected value of these contracts:
If a binary option settling at 0 or 1 is trading at 0.15, an investor who thinks it will become in the money 30% of the time would buy this contract, and sure enough, on expectation the payout will be 0 * 70% + 1 * 30% = 0.3. This trade would therefore on average make 0.3–0.15 = 0.15 profit per contract that they bought, a return of 100% on risked capital.
Pretty simple right? Binary option prices should fundamentally reflect the market’s opinion on the probability that an asset will finish above (or below) a certain strike.
Check out a sneak peek of the Zeta binary option interface. The contracts here are as simple as the one we’ve just walked through, so thinking about the probabilities you’re trading on is as simple as reading out the price.
Black-Scholes and binary options
Knowing that the price of binary options represents a probability often isn’t enough for discerning investors and traders. If you’re anything like us at Zeta, you’re wondering if there’s a surefire solution to determine the exact probability that an asset will be above or below a certain price.
The answer is very likely no — we don’t have an exact answer that will work all the time, but with the help of some clever people (shoutout Fischer Black, Myron Scholes, and Robert Merton), we’re able to get estimates that are hopefully close to the real deal.
We won’t go into the exact math (that will come in a later post) — but on a high level, if we take a few inputs like asset price, strike price, volatility and time, the Black-Scholes formula is able to produce its estimate of the probability of an asset like $SOL finishing above or below a certain strike.
This model is something we’ve created for the Black-Scholes price of a binary option expiring in one month. As time extends outward, the option price tends toward 0.5, as it intuitively becomes a coin toss whether the coin finishes above or below the strike. You’ll also notice some cool features like the gradient of the graph getting steeper as time goes to zero. There are a whole array of other properties for this option, and although we can’t explore them all here, we’d encourage exploring a model like this yourselves (instructions coming soon!).
But what about regular options?
Zeta is fully committed to building out a seamless derivatives trading experience. We think that building a binary options platform is a natural first step towards a fully-functioning vanilla options experience, and want to grow the sophistication of our platform alongside the sophistication of our user base.
Binary options are a perfect way to introduce you, our users, to taking measured risks, trading on Zeta’s low-latency interface, and interacting with Zeta’s unique on-chain risk management. Rest assured, vanilla options are on the way —and we’re as excited for them as you are!
We hope you enjoyed this post of ours, and are stoked to bring you more in due course!
As always, shoot down any questions, and we’ll try to answer as many of them as possible! Stay in touch with our progress and join the next wave of DeFi innovation by checking out our website, joining the Zeta Discord and following @ZetaMarkets on Twitter.