Relative value is a term used in both economics and sports betting that is very useful when you are trading with binary option. The relative value is the value of an investment when risk have been taken into consideration. The concept of relative value is very easy to learn but it takes a lot of knowledge to be able to apply it well. A skilled trader can use relative value to produce high returns on their investment.
Please observe that this article is not about Competitor Relative Value Trade Strategy. A strategy based on a similar concept but that is implemented in a very different way. The Competitor Relative Value Trade Strategy is best used when trading stock vs stock options or by hedging different binary options against each other.
The basic idea behind a strategy based on relative value is to get the knowledge you need to only invest in binary options that are giving a positive relative value. An option that will allow you to make money over time regardless of how any individual trade turns out.
How does it work. Lets pretend that you are planning to invest USD 100 in an option and that you get a 90% return on money if the option matures in the money. You lose all your money if it does not. This means that it is not enough to be right half of the time. Your goal in this situation should be to hit at least a 55% success-rate. A higher success rate is off course always better but 55% should be your benchmark for determining the minimum value required for you to invest in a binary option.
The 55% above is based on the numbers presented above. If the options you trade offer a lower return you need to use a higher benchmark. The benchmark should be set slightly above the break even point.
With the information above you know that you should only invest in options that according to your research and calculations have a probability of at least 55% to mature in the money. These options gives you a slightly positive relative value IE they will make you money over time. Any option with a lower probability should be avoided like the plague because they have a negative expected value.
The higher the likelihood is that a option will mature in the money the higher relative value they offer. A option that you calculate have a 72% chance of maturing in the money have a a lot higher relative value (value over time) for you than one with a 55% chance of maturing in the money.
Lets look at an example of the effects of changes in relative value over time. The example below is based on the assumption that we do the same trade (Trades with the same chance of maturing in the money) 100 times. We invest USD 100 each time and the return rate remains 90%.
55% chance of maturing in the money:
- 55 trades will mature in the money. These trades will earn you 4950
- 45 Trades will mature outside the money. These trades will cost you 4500
- You will make a small profit of USD 450 (4959-4500). This is not bad. But it could be much better.
72% chance of maturing in the money:
- 72 trades will mature in the money. These trades will earn you 6480
- 28 trades will mature outside of the money. These trades will cost you 2800
- You will make a respectable profit of 3680 (3480 – 2800). This a lot better and show how a relative small difference in the percentage of successful trades dramatically increase your profits.
The number used in the examples above is based on averages over time. Your experience over 100 trade can divert from this average. The more trades you do the closer to the averages you will get.
The most useful skill you can develop as a binary options trader is to be able to “accurately” predict the probability of a binary option to mature in the money and how this affect the relative value. You also need to learn how to find binary option with a good value.