First, a disclaimer: No I do not do binary options, and no I am not thinking about. I just happened across an article about them while browsing around, and a question came to mind which I’m kind of puzzled about.
If I understand correctly, the way it works is:
A binary option is, basically, a claim that commodity X will be above price Y at time Z. If you buy the option, and the claim turns out to be true, you get a hundred dollars. (Yes, as far as I can tell, it’s always exactly $100.) If you buy the option and the claim turns out to be false, you get zero dollars.
It appears the price is set by traders based on their ideas as to which stocks are going to meet these prices and which are not. So an option priced at $90 is one that most traders think will hit the specified price at the specified time, and one priced at $10 is one that most traders think will not hit the specified price at the specified time.
My puzzle arises from an assumption that, at very high or very low dollar amounts, the consensus of traders is more likely right than wrong.
But if that’s true, then it should be a winning strategy, on average, always to buy options with high dollar values, and sell options with low dollar values. (Because though the potential profit per transaction would be small, you would usually “win” so over time you’d make money.)
But if it were that simple, everyone would figure this out, and those high dollar values (due to demand) would get higher and higher til they were no longer even worth offering. (Not enough to make up for transaction fees for example.) And the whole market would crash.
So then, maybe I’m wrong to think that the consensus of traders, at least when it comes to the more extreme dollar values, is more likely right than wrong. Should I be surprised if this is so? Wisdom of crowds and all that. And if I’m wrong, then this would mean that the prices have no predictive value whatsoever, and that, really, doesn’t that seem surprising if true?
Or maybe I’m wrong to think that if this is a clear winning strategy, everybody would figure it out and the market would crash.
Well what do you think?
