Binary options provide traders an opportunity to trade assets from multiple global markets, but they are not the same as traditional options. They have different payouts, fees, risks and liquidity structure and investment processes. Binary options that are traded outside the United States are structured differently than those available on the U.S. exchanges. Binaries are often looked at as an alternative investment or hedging option, but a thorough understanding as to how binaries work is essential to benefit from binary options trading.
Binary Options – What Are They
Binary options, also referred to as exotic options, are both easy to understand and trade. They are a type of option wherein the payoff is either a fixed amount of money or nothing at all. This is to say that the outcome of a trade option is based on a yes or no proposition, hence the name binary options. A binary option is automatically exercised, meaning the holder of the option is not required to either buy or sell an underlying asset.
Mainly, there are two types of binary options: cash-or-nothing and asset-or-nothing types. In the case of cash-or-nothing type, a pre-determined amount is paid if the outcome of the trade is successful. On the other hand, the underlying security’s value is paid when dealing with asset-or-nothing options. Binary options are also referred to as digital options (in the forex market), fixed return options (on the Amex) and all-or-nothing options.
The most important aspect of binary trading is that you will be aware of the return you can expect from the trade prior to purchasing the options. Further, traders can buy binary options on almost all types of financial products and all they have to do is just predict whether the price of an underlying asset will increase or decrease by a specific time period, referred to as the expiration period of the binary options contract. The contract expiration period can range from one minute or even less to one hour, a day or even a week. Typically, cash-settled binary options are referred to as European-style options, meaning traders can exercise options only after the completion of the expiration period.
Binary Options Trading – What Does It Involve
Binary trading involves traders predicting the direction that the price of an underlying asset will take with reference to a specific level (referred to as the Strike Price) by the end of the contract expiration period. In the case of most of the high-low binary options offered outside the U.S., the current price of the underlying stock is its ‘Strike Price’. Trading in binary options is often facilitated through online platforms by brokers.
The “high-low” options are the most frequently traded binary options. Traders are provided access to binary options in stocks, commodities, indices and currencies from around the world by most brokers. If the trader’s prediction is correct and the price of the underlying asset is on the right side of the Strike Price, then the trader becomes eligible for a fixed return on the amount invested in the trade irrespective of how much the price has moved. On the other hand, if the trader’s prediction turns out to be incorrect, he/she will lose the amount invested in the particular trade.
Within most of the binary options trading platforms, traders can predict the direction of the price of the underlying asset by selecting a ‘Call’ or ‘Put’ option. The ‘Call’ option refers to an increase and the ‘Put’ option corresponds to a decline in the price of the chosen underlying asset. It is not necessary that traders predict the amount by which the price will increase or decrease as in the case of traditional or vanilla options.
The binary trading is best illustrated with the help of an example:
Binary Options Type: Cash or nothing
Prediction: Trader buys ‘Call’ option on a Company’s stock
Strike Price: $100
Payout for Successful Outcome: 80 percent
Contract expiration time: 60 minutes
Investment in the Trade: $100
At the end of one hour, if the company’s stock trades at or more than $100 per share, the trader will receive a payout of $180. If the stock’s price falls below $100 by the contract expiration time, the trader gets nothing. However, in practice, some brokers return a portion of the investment $10 to $15 or 10 to 15 percent so as to help traders minimize their losses.
Exchange-traded Binary Options
The Securities and Exchange Commission in the US permitted the listing of cash-or-nothing options in the year 2008 following the amendment to certain rules proposed by the Options Clearing Corporation. In the same year, exchange-traded cash-or-nothing European style binary options were offered by the American Stock Exchange (Amex) as well as the Chicago Board Options Exchange (CBOE).
Whereas Amex makes available Fixed Return Options trades on Exchange-traded Funds and stocks, the CBOE offers binary options on indices. The Nadex started offering binary options trades in 2009. Nadex offers binary options on varied assets, including commodities, currencies and indices.
Non Exchange-traded Binary Options
Non exchange-traded binary options are offered by online binary options brokers. These options also became available by 2008. Binary options offered by online brokers are simplified versions of the exchange-traded binary options. Hundreds of binary options trading platforms are available as of now and they offer options on a large number of underlying assets. These platforms specialize in offering standardized binary options and short contract expiration periods. Typically, the options cannot be liquidated prior to expiry, unless allowed by the broker.
Summarizing, the popularity of binary options trading has increased a great deal over the years because of its simplicity. They are easy to understand and very simple to trade, especially when compared with vanilla options. There is also a great deal of predictability in terms of the profits and losses that traders can make or incur. In fact, they get to know of it even before they place the trade. However, before embarking on a career in binary options trading, traders should develop a clear understanding as to how the binary options market works.