Inventory and risk in binary markets
Why exposure is counted by event rather than by contract, why fills in a binary market often come from better-informed traders, and how inventory and edge set the size.
A position in a binary contract has a known floor and a known ceiling: at settlement it is worth zero or one, and nothing in between. That makes some risks simpler than in other markets and others much sharper. Managing inventory well starts from the shape of the payoff.
The payoff is a step
Buy at 0.40 and the result is plus 0.60 or minus 0.40 a contract. There is no tail beyond that, so the worst case of any single position is easy to state. The path to settlement is another matter. In a live event a single moment, a goal, a kill, a data release, can move the fair price from 0.40 to 0.85 in under a second. Volatility arrives in jumps, and a position cannot be hedged across a jump by trading after it.
Exposure is to events, not to contracts
Contracts on the same event are rarely independent. A match winner, a total, a handicap and a first scorer all move on the same goals. So positions are added up by the underlying event and by the states it can end in, not contract by contract, and the question to answer is how much is lost in each plausible final state. Two positions that look small on their own can be the same bet twice.
The same holds across events that share a cause: games on the same evening's slate, temperature contracts for cities under the same weather system, crypto contracts on assets that move together. Limits are set on these groups as well as on single contracts.
Who is on the other side
A resting order is filled when someone chooses to hit it. In a binary market, the counterparty who chooses to trade at a given instant often knows something: the event has just happened, the source has just updated, the quote is stale. This is adverse selection, and it is sharper here than in most markets because information arrives as discrete events rather than as a steady flow.
Two consequences follow. A resting quote has to be pulled faster than the fastest informed trader can hit it, or be priced wide enough to be paid for the risk of not being pulled. And fills are judged by what the price did after them, not by how many there were. A quote that is filled often and then watches the price move against it every time is a service to better-informed traders.
Inventory moves the price you should quote
A trader who already holds a position should not quote as if he held none. A long position makes the next contract less attractive to buy and more attractive to sell, so quotes are shifted toward reducing it and the size offered shrinks as exposure grows. The price at which the trader is indifferent to one more contract moves with inventory, and the quotes sit around that price rather than around the market's midpoint.
In a binary market this matters more as settlement approaches. A position that could be worked out gradually early in an event becomes one that can only be held or dumped at a poor price late in it, so the shift should grow as time runs out.
Sizing
How much to hold in a single outcome depends on the edge and on what the capital can sit through. The Kelly criterion gives the fraction of capital that maximises long-run growth for a known edge. In practice the edge is an estimate, the estimate is noisy, and full Kelly on a noisy estimate bets too much. A fraction of it, with a cap on any single event and on any group of related ones, keeps most of the growth at far less variance, and leaves room for an edge that turns out smaller than estimated.
For strategies that make most of their money from a few large wins, the typical trade is a poor guide. The question is how long a losing run the capital can survive while it waits for the wins, and that question is answered on the strategy's own record, run through many reorderings of its days, before size is chosen.
Near settlement
As resolution approaches, liquidity thins and prices run toward the ends. The last few cents between 0.97 and 1.00 pay for the risk that remains: a late event, a revision, a dispute over the rules. Holding to settlement is a decision to take that risk at that price, not a default, and it is made the same way as every other decision: on what the remaining cents are worth against what they cover.