Why they might not even need to sell:
I took a quick look at the Nadex spreads and for a 20 minute At-the-money S&P option the bid-ask spread is between 5-10%. Although a 5% spread may seem cheap, lets look at the expected distribution of PNL on a given day.
Assume you can sell $100 Notional worth of ATM Binary Calls for 55% or 52.5%
Assume you do this 18 times a day (
3x / hour + time for lunch for simplicity)
Assume the underlying of this option has equal chance of going up or down.
The expected profit is then (10,000 simulations)
10% Spread: mean: 89.8 std: 209.8 Sharpe: 0.42 Annual Sharpe: 6.8*
5% Spread: mean: 45.0 std: 211.2 Sharpe: 0.21 Annual Sharpe: 3.4
*Its good to be king. As a buyer of these exotics, remember that your expected alpha has to be greater than the market makers expected alpha. Its a 0-sum game remember.
If you wanted to hedge an exotic option
This can get complicated, but it is often the easiest to view a binary option as a simple in the money call spread. A binary option with strike `k` can be approximated by a long call option with strike `k-e` and a short option at `k+e`.
A lot can be said about hedging this portfolio. Some food for thought:
When the option expires, the binary option risk goes away but no you have to remove your hedges quick! What if the market is closed?
The deltas get very large near expiry (theoretical deltas can be over 1000%. How does this compare with liquidity of the market, transaction costs and your view?
Event risk. Binary options (especially far out-of-the-money options have huge jump risk. How good are your models as seeing this? Do they assume uniform forward vol?
Local mean reversion or intra-day trending: Option models usually don't have these features, make sure that this is good assumption.
Correlation between markets, if you are trading a portfolio across time or securities, need better ways to view and price this correlation
What other dynamics should be incorporated?
** Legal Disclaimer: The information above is for illustration only. This is not a recommendation or solicitation to buy or sell anything. Sean Kruzel has no affiliation with Nadex or any other options trading firm.
Written 7w ago • Not for Reproduction