Binary Options vs. Options
What is the difference between binary options and options?
In case you’re just learning the ropes about trading, you might struggle to tell Options and Binary Options apart.
Before you invest in something, it’s always advisable that you try and learn as much as you can about it, so that you understand the investment vehicle you’re putting your money into and the features.
Understanding binary options and the conventional options, you have to take the time to learn the differences between these in-depth before you can invest your money.
What Are Options? Options Trading 101
Options are derivative financial instruments, in that they depend on other assets. The value of an option depends on the value of another asset. Options give the holder a right, but not obligation to buy or sell the underlying asset at a given time in the future. This is one of the main differences between options and other derivatives like futures. As an option holder, you do not necessarily have to act on the underlying contract if you feel it is not going to be profitable for you in the long run.
There are so many financial instruments upon which options can be written, including credit ratings, bonds, interest rates, forex, equity, and commodities. For hundreds of years, options have been used as financial instruments for different reasons. Some of the earliest known options were used in Greece by farmers who would hedge their olives. Since then, options have advanced and have been used as financial instruments in several instances over the years.
Options would, later on, evolve to be traded on equities as stock options, and interest rates as swap options. Later on, they evolved into a unique class of assets and were eventually listed in the Chicago Mercantile Exchange in 1973. This exposed options to a large market from where they gained complete liquidity as would assets in traditional stock markets.
While the concept of options might not be very easy to grasp, there are some options basics that you can learn, which will go a long way in helping you learn how to trade in options and option trading strategies . Whether you are a quantitative trader or not, mastering these concepts will help you secure better returns from your investments, especially if you are trading options for income or trading options for a living.
- Current and Strike Price
The current price (S) and the Strike price (K) are two of the most important factors that are used when determining the payoff and price for the options. The current asset price is the price at which the asset is available in the market. This is self-explanatory. The strike price, on the other hand, is the price that is agreed upon, at which the option holder might sell or buy the asset when the option expires.
- Time to Expiry
This is a preset time in the foreseeable future upon which the option will expire. In European options, traders are restricted at this time, as the only moment in time when they can buy or sell the options. American options, on the other hand, are more flexible, allowing traders the freedom to exit the trade at any given time before the option expires.
The time to expiry exists within a range and can be a few weeks, months or even years into the future. The expiry date is also important in setting the price of the options. Holding all factors constant, options that exist for a longer period are usually more valuable than short-term options.
- CALL or PUT
When you invest in a call option, you are buying the right to buy the underlying asset at an agreed rate in the foreseeable future.
Puts, on the other hand, give you the option of selling the underlying asset at a given time in the foreseeable future. A call, therefore, can be viewed as a bullish (long) perspective of an asset while a put is the opposite, a bearish, (short) perspective of the market.
- Option Moneyness
When options trading, you will come across two important terms, in the money and out of the money. What these terms allude to is whether the trade will be feasible for the trader to make profits at the prevailing price. In the case of a trader who has a call option, he is in the money if the price of the underlying asset (S) is higher than the strike price of the same asset (K).
On the other hand, a put option is said to be in the money in case the price of the asset falls below the strike price. In a situation where exercising the option would not be in the best interest of the holder, and it would be better if they let the option expire and become worthless, this is where the investor is out of the money.
- Price Volatility
When determining the price of options, the volatility of the options is another factor that is taken into consideration. Volatility determines how the value of the underlying asset changes in the market, and as a result, the price of the option. It is simply a factor that determines how high or low the price of the asset varies from a given mean.
Options that are offered on assets that are more volatile are considerably more expensive, and as a result, their prices tend to be in and out of the money from time to time.
When the option expires, the investor earns a payoff. If the option expired in the money, the payoff is positive. The payoff is calculated as the difference between the strike price and the asset price. For call options, it is calculated as S-K and K-S in the case of a put option.
The price of the option can also be referred to as the premium. It is a premium because, in essence, the investor is buying protection just in the same way that we buy insurance premiums. When the trader invests in an option, the highest amount they can lose on this investment is the amount that is marked as the premium.
An Option Illustration – Options trading tutorial
The following is a graphical illustration showing a payoff for a call option, which can help you understand how options work.
The asset price is indicated on the x-axis, while the profit or loss is indicated on the y-axis.
The option strike price (K) is 110. If we consider the structure of the payoff, from this illustration, we have an asymmetric payoff. The highest loss that the trader can risk is the premium on the option, which happens only if the option is out of the money.
A good thing about this investment, however, is that there are unlimited options for profit making. This is why most people consider options as a very good derivative investment instrument. This approach, however, takes a simplistic view, because, in reality, the price of options tends to vary depending on the volatility of the underlying asset, and time to expiry of the option.
Benefits of Investing in Options
When you consider how the price of options is set, and the nature of the payoffs, you will notice that there are several benefits that you can derive from options trading. For sophisticated traders, most of these benefits do apply. However, even for a retail investor, you can still learn so much in the process.
- Leveraged Trade
When you invest in an option, you are leveraging your trade on an asset, that the value will appraise. If you pay the premium, in theory, you should be able to get a good payoff, especially if the trade turns out in your favor.
- Maximum Loss
One of the best things about investing in options is that there is always a level of security in that as a trader, you are already aware of the maximum possible loss that you might incur if the market takes a dive. This is the premium you invest when you buy an option.
- Unique Strategies
Options have an asymmetric payoff system, which means that as a trader, you can consider using different strategies to invest in options. Some of the common strategies that have been used by shrewd traders in the past successfully include bull and bear spreads.
- Trade Any Asset
You do not necessarily need to hold an underlying asset to trade in an option. For this reason, you have the chance of investing in something that you might not be able to purchase physically. If, for example, you want to invest in a long position in the S&P 500 index, you can simply do this by taking a call option on it.
- Trade Underlying Volatility
Investors who have been trading in options for a long time have a better perspective of this. By trading on the volatility of the asset, these are investors who wager their money on the effect that the price of the asset will have on the option.
Binary Option Payoff
The main features of binary options are similar to the traditional options. The same inputs apply even when setting prices for binary options. The main difference between these two, however, is the payoff structure when binary options expire.
When binary options expire, there can only be two possible outcomes, either 100 or 0. It is for this reason why binary options are at times referred to as digital or binary options. In the case of vanilla options, on the other hand, the expected payoff is variable.
In the illustration below, we have the expiry and payout matrix for an option. You will notice that unlike a scenario where we have traditional options, the payoff matrix here has a limit. Therefore, however, high the price of the asset rises, this is the only gain that the trader will make.
Over the years, binary options have always been trader by hedge funds and large investment banks in over the counter (OTC) markets. Considering the nature of the binary options payoff, some investors tend to shy away from them because they are difficult assets to trade.
Retail Binary Options Market
Confidence had been lost in binary options trading in the retail market, at least until 2008. Investors who primarily traded on CFDs and Forex were now able to use a different investment instrument for trade. These are investors who did not necessarily need to know about the underlying asset for them to preemptively wager on the direction the price of the asset will move.
Binary options trading then evolved to allow investors to trade with expiry windows as small as 1 minute apart, which was a new strategy in options investments. Other than that, the trades became simpler such that traders were able to predict the direction of the market in a few minutes.
The payoff is arrived at as a portion of the profit the investor makes on the trade. Therefore, if the position ends up in the money, the payoff would be between 50% and 80% of the principal sum that the trader invested as capital.
There are instances where retail binary options can be traded as variants of European options. This particularly applies in cases where the trader has to wait for a while until the option expires. Conversely, most traditional vanilla options can be executed even before they expire.
There are some traders who prefer binary options trading based on speculation, which simply means they are not investing, but are gambling. Investment banks struggled to reign in binary options and over time they evolved into one of the simplest methods of investing by retail traders.
Binary Option Pricing
A lot of investors consider binary options to betting on the possible movement of an underlying asset. However, it is still a form of investment that they take seriously. Compared to traditional options investments, the investor does not always have to study the factors that affect the price of the binary options.
You do not need to study and interpret all the dynamics that affect the price of options, for you to trade in binary options. All you have to do is speculatively decide on what you think the value of the asset will be and place your bet.
Traditional options trading is not common in retail trading platforms. The reason for this is because there are so many requirements to open and maintain the account. Therefore, this deters a lot of people who would want to make quick cash. With binary options, however, brokers usually have very few requirements, and you can start with at least $10.
For new traders who are looking to invest in an asset over a short period of time, binary options trading would be a good idea. If you have more funds at your disposal, you can consider investing in traditional vanilla options.