Binary Options Tunnel definition and price profile
This post is published by Hamish Raw of https://hamishraw.com/
The binary options tunnel, a.k.a. binary options corridors or rangebets, are all-or-nothing binary options that settle at 100 if the underlying is between the strikes at expiry, or at zero if outside the strikes at expiry.
The binary options tunnel buyer is similar to a conventional condor buyer in that they are both speculating that the underlying will be between the two strikes at expiry. The difference between the two strategies is that the condor has an extra two strikes outside the inner two strikes so that the expiry settlement price profile slopes down from the inner two strikes to the outer two strikes, in effect a long call spread with a short call spread above it. In contrast the binary options tunnel has the strikes dropping from the two strikes vertically to zero as depicted by Figure 1.
In Figure 1 the settlement price is zero outside the strikes and 100 inside. Should the underlying settle exactly on either strike, then adopting the ‘dead heat’ rule would create a settlement price of 50.
In calculating the value of the binary options tunnel it is more akin to a conventional call spread, i.e. subtract the value of the upper strike binary call option from the value of the lower strike binary call option.
In the Soybean illustration of Figure 2 the middle point between the strikes is at 1200. If the 1250 binary call is worth 25 one might reasonably expect that the 1150 binary put to also be worth somewhere close to 25, hence the 1150 binary call will be worth 75. The binary options tunnel would then be valued as:
Soybeans 1150/1250 Binary Options Tunnel = 1150 binary call – 1250 binary call
= 75 – 25
For the 1150 binary put to be the same as the 1250 binary call would require:
- Interest rates are zero so no cost of carry
- The implied volatility of the 1150 binary put is the same as the 1250 binary call
- That a normal bell-shaped distribution applies.
The binary options tunnel is clearly a volatility play if the binary options tunnel is bought or sold with the underlying price already within the two strikes. Figure 3 illustrates the soybean 1150/1250 binary options tunnel over a range of implied volatilities.
A buyer of the binary options tunnel may believe that the implied volatility is too high as, for example, a series of national holidays are coming up with traders thoughts diverted away from trading and more on their sun tan lotion. If on the other hand the speculator believes the market will become more volatile a sale of the binary options tunnel would be appropriate.
Example: the trader who believes that the soybeans market may become less volatile might consider that the probability of the soybeans price being over 1250 at expiry only 15%, i.e. the binary call should be worth 10 ticks less than at present. This would suggest that the 1150 binary put should be only worth 15, leading to the 1150 binary call being worth 85. This would imply a binary options tunnel price of 70 which in itself is implying that there is a 70% chance of the underlying being between the strikes as opposed to the current 50% market forecast.
If the binary options tunnel was out-of-the-money when bought then the trade is a directional play as the buyer is speculating that the underlying is going to move towards the strikes.
If, with the underlying at 1200 a trader fancies the market up then they could buy the 1250 binary call for 25. Should the trader be correct and the market rises to 1250 then the trader might sell his binary call at 50 and close out for a 25 profit. Alternatively he may hang on and wait for the underlying to rise to 1300 where he may sell the 1350 binary call for 25. At this point the trader has bought the Soybean 1250/1350 binary options tunnel for zero. Should the trader instead hang on for the underlying to trade 1350 then the 1350 binary call could be sold for 50, meaning that the trader has now banked a profit of 25 along with owning the 1250/1350 binary options tunnel for nothing. In effect the trader has paid -25 for the binary options tunnel which has to settle between 0 and 100.
‘Legging’ into structured positions, such as the tunnel, could become an important part of the everyday strategy of the binary trader. The strategies with two strikes are the tunnel and eachway binary call and eachway binary put and these strategies offer the best potential for legging into winning, no loss scenario positions.