I assume this is for a payout of 100,correct? What do you notice with expirations > than 10 days. any boot-strap techniques for longer expiration options?
no , the payout is for every 1$ ( the odds in the example above are just 7% if you took the "will happen" bet). I think it will work with exp>10 , but then one needs more historical data (300 days , 500 ?) and some reference to Stats Vols. I build this type of calculator when I was following Riskarb journal , and the odds/payouts were pretty much close to his real trades( I use to multiply my payout result by .88 to include broker edge).
OK, back to first principles...pls explain the need for your step 3. I see the 7% odds, but why the inverse. What would be the premium paid using your example? and the corresponding payout to that premium? I am assuming the adjustment for house edge could be either .88 or 1.12?? Thanks!
1. Its easy to double check , payout must add to "zero sum game" (lol). 7% chance means : When you take this bet 100 times , you will pay 100 times 1$(100$ total) You will win 7 times , 14.3$ each for a total of 100$. The sum is zero. 2. The reverse(will NOT happen) payout is (100/93=1.07 for every 1$) 3. By multiplying the payout by amount than less than 1 , you reducing the payout ( house edge). In case of 0.88 the house edge is 14%(100/114=apr .88)
Thx! It does seem that for soemtrades adjusting for the house edge using say a 14% vig eliminates any chance of profit....? Or am I missing something...again?
to calculate your "friendly" broker edge : 1. Cash needed to win 100$ on some "Touch" bet (let say its 60$ to win a 100) 2. Use the SAME condition for a "No touch" bet ( 57$ to win a 100$) 3 Add both bets and now you must pay 117$ to guarantee a 100$ win. The house edge in this case is (1-(100/117))*100=15%. Riskarb stated once that house edge is smaller for a very liquid markets like FX ( 5-8%)
Thx! I understand this..even though I arrive at the same result using a different approach: 57- (100-60)/(57+60)..but that's irrelevant. I wonder do dealers always try and hedge their book or just 'foolishly" rely on their edge to remain profitable.
not sure about hedging , but a second strategy works well for uncle Vito from barber shop for many years now , hahaha
The pricing is only representative of the moment. Initial edge loss isn't a practical concern beyond "relative value". A 7day binary touch will lose approximately 15% of value due to one day's decay at static vol+spot price. Initial edge and vol is more critical for longer dated binaries; short dated binaries are priced by their initial delta, gamma, dgamma. The curvature of gamma is an overwhelming influence as all binary-barriers are traded otm. Run the house edge as IV has kindly suggested as well and the decay @ static vol+price for one day. Try to maintain 1d decay > house edge. The 1/7 ratio is a good parm for all maturities.