Volatility is an important concept when it comes to binary options trading, and this is where concepts like Theta become useful for binary options traders. This is a measuring tool used when attempting to compare an asset’s price with the amount of time left in the option that you are looking at. Knowing how to calculate this number, and then how it applies to your trade, will give you a good idea of the amount of risk that you are taking on, along with how to base future trades off of the information that you are gathering. Before you apply this trading strategy, be sure that you know the benefits and the drawbacks of using it.
Application of Theta
Theta is a measurement of the amount of time left before an options contract expires. With traditional options, theta is typically used as a way to calculate the decay of the contract. With binary options, it lets you know how likely your option is to finish in the money. In essence, what theta is actually measuring is the rate at which your option will lose value. With traditional options, this would be measured as dollars lost per day where a theta of 50 meant that you were losing $50 per day if you delayed.
In binary options, trades are left open for far shorter periods of time. Instead of months, we deal with hours. Instead or weeks, we deal with minutes. Theta will have radically different meaning for an option that expires in 15 minutes than it will in one that expires in 15 months.
The value of theta for your trading needs to start with where you expect prices to be. If you are looking at Apple’s stock, for example, and expect it to be at $100.50 by the end of the day, theta changes as the price moves. Let’s say that you have a very strong reason to believe that this is the price that it will close the day at, and there are two hours left in the trading day. If the price is currently at $99.50, there is $1 in movement left, and three hours to go. As the price creeps up, time goes by. At $100, there will no longer be three hours left in the trading day, and therefore, your expected value from this trade will have changed. If there’s only two hours left, and you have not yet made your trade, you have lost money because the trade that you were going to take out—a call options—would now be in the money and you have lost time that would have worked in your favor.
There’s no precise way to measure theta in binary options and this has led to many people not using it at all. But, as a general concept, it is a good way to look at the opportunity of initiating a trade, and the cost of not initiating a trade.
Drawbacks do Occur
Theta is what is called a “theoretical indicator.” It has no practical application like many other pieces of technical data, but is instead a manmade measurement to try and measure abstract pieces of information. As a result of this, the number that you find will not have much meaning when looked at on its own. You need other pieces of data to compare the theta that you find with, and only then will you come up with a valuable trading strategy.
Theta is notoriously difficult to apply to binary options because it is more of a philosophy or risk management principle than anything else. As such, beginning traders shouldn’t even attempt to utilize it. But, as you grow more experienced and start to look for ways to optimize your trades, this is a valuable concept to apply.
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