Upbet Pricing

Fig 1.2.1 illustrates the expiry price profile of an upbet. One of the
features of binaries is that at expiry, bets have a discontinuous distribution,
i.e. there is a gap between the winning and losing bet price. Bets don’t
‘almost’ win and settle at, say 99, but are ‘black and white’; they’ve either
(except in the case of a ‘dead heat’) won or lost and settle at either 100
or zero respectively.
1. If the upbet is in-the-money, i.e. in the above example of Fig 1.1.1 the
underlying is higher than $101, then the upbet has won and has a
value of 100.
2. Alternatively if the upbet is out-of-the-money, i.e. the underlying is lower
than $101, then the upbet has lost and therefore has a value of zero.
3. In the case of the underlying finishing exactly on the strike price of
$101, i.e. the upbet is at-the-money, then the bet may settle at 0, 50
or 100 depending on the rules or contract specification.
One issuer of binaries may stipulate that there are only two alternatives, a
winning bet whereby the underlying has to finish above $101, or a losing
bet whereby the underlying finishes below or exactly on $101. A second
company might issue exactly the same binary but with the contract
specification that if the underlying finishes exactly on the strike then the bet
wins. A third company may consider that the underlying finishing exactly
on the strike is a special case and call it a ‘draw’, ‘tie’ or ‘dead heat’,
whereby the upbet will settle at 50. This company’s rules therefore allow
three possible upbet settlement prices at the expiry of the bet.
N.B. Throughout the examples in this book the latter approach will be
adopted whereby in the event that a bet is a ‘dead heat’, or in other
words, where the underlying is exactly on the strike price at expiry, then
it is settled at 50.
1.3 Upbet Profit & Loss Profiles
The purchaser of a binary option, just like a conventional option, can
only lose the amount spent on the premium. If Trader A paid 40 for an
upbet at $1 per point then Trader A can lose a maximum of just 40 × $1
= $40. But with a binary not only the loss has a maximum limit but the
potential profit has a maximum limit also. So although Trader A’s loss is
limited to $40, his profit is limited to (100 – 40) × $1 = $60. As a general
rule the profit and loss of the buyer and seller of any binary must sum to
100 × $ per point.
In Figs 1.3.1 and 1.3.2 respectively Trader A’s and Trader B’s P&L profiles
are illustrated. Both traders are taking opposite views on whether a share
price will be above $101 at the expiry of the upbet.
In Fig 1.3.1 Trader A has bought the upbet at a price of 40 for $1 per point
($1/pt) so his three possible outcomes are:
1. Trader A loses $40 at any level of the underlying below $101.
2. At $101 the rules of this particular upbet determine a ‘dead heat’ has
taken place and the upbet settles at 50 with Trader A making a profit
of $10.
3. Above $101 Trader A wins outright and the upbet is settled at 100 to
generate a profit of $60.