What are Binary Options?
Binary options are financial derivatives that allow investors to bet on short-term price movements across various financial markets and securities. They are named “binary” because there are only two possible outcomes at expiration.
In most cases, there is a fixed cash payment (typically $100 per contract) if the trader predicts the direction the price will take correctly or nothing at all.
Binary options offer traders a unique way to operate with different financial assets including forex, stocks, commodities, or indices. These derivatives allow traders to speculate on very short-term price movements without taking ownership of the underlying assets.
The risk assumed is limited to the premium paid – the cost of the binary option. Meanwhile, the maximum gain, if the option expires in the money, is also fixed it is determined when the position is opened. This structure of fixed risk and reward is a key characteristic that sets binary options apart from more traditional options and other types of trading.
How Does a Binary Option Work?
The practical functioning of a binary option is relatively straightforward. First, a trader must select an underlying asset made available by their preferred binary options broker. Common assets include major forex pairs like EUR/USD or USD/JPY, major stock indices like the S&P 500 or FTSE 100, commodities such as oil and gold, and individual stocks.
Next, the trader must select a fixed payout expiration time. The usual time frames range from 30 seconds to one year, the majority being on the very short-term side. They also stipulate the trade size or stake and whether the underlying asset will settle above (in-the-money) or below (out-of-the-money) the current price.
If the trader’s prediction is accurate, the binary option settles at $100 at expiration, and they receive the pre-determined payout. If the prediction is incorrect, the option expires worthless, and the trader loses their initial stake.
Types of Binary Options
We have already shared the meaning of binary options. Now, while all binary options operate on a fixed risk, fixed reward basis, traders can use several different varieties to profit from predicting short-term market movements.
The most common types of binary options contracts include:
|Also known as up/down, call/put, or rise/fall binary options. This is the most common type of binary option where traders attempt to predict if the price of the underlying asset will rise or fall past the strike price at expiration. The payout is fixed if correct while losses are limited to the premium paid to open the position.
|One-touch options define a specific price target that must traded at least once before expiration in order to receive the fixed payout. Even if the price subsequently moves far higher or lower, the predetermined payout is guaranteed once that strike price is hit.
|These are the opposite of one-touch options. To profit from no-touch options, the trader selects a price target and predicts that the asset will NOT trade at or beyond that barrier before the option expires. The fixed payout is received if that premise is correct.
|Also referred to as tunnel or boundary binary options. Rather than a single price barrier, in/out or range options require that prices remain within a predetermined upper and lower limit to earn the payout once the option settles.
|Ladder binary options operate with a pricing system that offers incrementally higher payouts depending on how far away the market price moves through predetermined barrier levels upon expiration. The further away from the strike, the higher the fixed return rate.
How to Trade Binary Options?
Our binary options definition is complete up to this point. It is time to learn how to operate with these derivatives in practice.
The best binary options brokers simplify things for beginners by providing access to user-friendly interfaces through which they can trade these derivatives.
To execute a successful binary options trade, traders usually go through these simple steps:
- Select an asset to trade – e.g. a stock, currency, commodity, or index.
- Choose a fixed trade stake amount – e.g. $1 per point.
- Pick the direction of the trade (higher or lower than the current price).
- Select an expiration time for the option – 30 seconds, 1 hour, or end of day.
- Execute the trade and wait for the outcome.
Once all parameters are configured, the payout is fixed. For example, setting a $50 stake on gold going higher at the end of the trading day. The maximum risk is $50 and the maximum profit might be 70% of this amount, or $35.
The only action that traders need to take after the trade confirmation is provided is to wait for the contract’s expiration and see if the asset’s price settled as they predicted or not. If it closed higher, based on this example, a total of $85 will be paid out – $50 stake plus $35 profit. Meanwhile, if the price of gold closes below that threshold at settlement, the trade would expire worthless and the trader would lose $50.
Binary Options Trading Strategies
There are several strategic approaches that traders utilize when trading binary options. Some of the most binary options trading strategies include:
- Trend Strategy: Trend trading involves identifying if an asset price is moving clearly in an upward or downward trajectory. Once the trend is identified, traders can buy calls or put options accordingly to take advantage of the trend’s continuation. Technical analysis is used to predict the trend’s direction and entry signals.
- Reversal Strategy: This strategy seeks to identify potential price trend reversals to capitalize on the directional change. Technical indicators like the RSI or MACD are used to identify oversold/overbought binary options trading signals that often precede a reversal. Entry positions are taken contrary to the prevailing trend.
- Range Trading Strategy: Range trading aims to identify assets trading within relatively narrow price bands or channel ranges. Traders buy in-range call and put options or ladder options to profit from this type of price action.
- News Trading Strategy: This approach revolves around trading binary options during major news events or data releases. The strategy hinges on the strong volatility triggered by relevant events to generate quick profits from tradable price swings over very short timeframes.
- Technical Analysis Strategy: Utilizing chart patterns, indicators, and other technical studies to identify trading signals and entry points based on technical parameters as opposed to fundamental triggers or events. This technique is applied to range trading, trend trading, or reversal trading approaches.
Binary Options vs. Vanilla Options
There are some distinct differences between binary options and vanilla options. The main ones are the fixed risk nature of binaries and the element of a fixed payout at expiration if the contract expires in the money.
Traditional options allow traders to leverage their positions. When writing traditional options, losses can be unlimited but profits are capped at the premium collected. The opposite goes for buying a vanilla option as profits are unlimited while losses are limited to the premium paid by the trader.
If a trader’s view is correct, binary options always provide a full payout. Hence, profits can be taken without having to own the underlying asset or trade out of a position in a volatile market.
Binary options trading, therefore provides a very clear risk/reward ratio. The capped potential loss and capped potential profit simplify risk management enormously compared to other derivatives like futures and vanilla options.
How are Binary Options Regulated in the US?
In the United States, the regulatory body for binary options trading and brokerages is the Commodity Futures Trading Commission (CFTC). Under CFTC rules, any trading in binary options must be conducted on exchanges that have been authorized to provide these services. Off-exchange binary options trading is illegal in this country.
The CFTC’s mandate is to protect traders by ensuring that all US-registered binary options exchanges offer transparent trading, full regulatory oversight, and account protection through segregated merchant banking. The regulatory framework around binaries exists to mitigate insolvency risks and protect investors.
There are only three regulated binary options exchanges in the US. These are:
- The North American Derivatives Exchange (NADEX).
- Cantor Exchange (CX).
- The Chicago Mercantile Exchange (CME).
All reputable brokers will hold full licensing and regulatory registration for the jurisdiction within which they operate. Licensing guarantees certain standards of platform robustness, trade execution, price transparency, and dispute resolution.
Advantages of Binary Options Trading
There are multiple advantages to using binary options when trading in the financial markets:
- Fixed and limited risk and reward profile on every trade.
- Ability to profit in both bull and bear markets.
- Opportunity to earn money over very short time frames.
- User-friendly platforms and simple trading process.
- Low barriers to entry, both in terms of capital and experience.
- Built-in systems for risk control and leverage limitations.
Disadvantages of Binary Options Trading
There are also various downsides to trading binary options that traders must be aware of:
- Rewards are capped.
- Capping profits limits traders’ ability to let winning positions run.
- Longer-term trading strategies cannot be implemented.
- Traders must accurately predict the direction that the price of the security will take to profit. This is quite difficult to achieve in practice.
- Broker spreads and fees can erode profits.
- Early closure means little flexibility and potential missed opportunities if prices keep moving favorably after the option expires.
- Significant levels of fraud exist in unregulated markets.
- The odds are generally stacked against the trader.
Example of Binary Options Trading
An options trader believes that gold prices will rise over the next hour and he wants to open a binary option position to take advantage of this prediction. Gold call binary options offer a 75% payout.
The trader follows these steps to open the position:
- Searches and selects gold as his trading asset within the broker’s trading interface.
- Stake $100 on a binary call option. This is an option that favors the trader if the price of the underlying securities increases.
- The option has a 50-minute expiration time.
- If gold trades higher than the strike price in 50 minutes, the payout at expiration will be $175. This is the sum of $100 (the stake) and the $75 payout he earned.
- If gold trades lower than the strike price at expiration, the entire $100 stake is lost
In this example, the trader is speculating that gold will rise in 50 minutes based on his bullish prediction. The maximum downside on the trade is the $100 premium paid for the binary contract. The maximum payout, in this case, would be $175 (including the stake).