How Does Trading Binary Options Work
What is binary options trading?
Trading binary options is simply a yes or no situation. Investors speculate whether the value of an underlying asset will, at a given point in time, be above or below a specific price. Traders, therefore, are able to place their trades depending on whether they believe the value will be higher or lower. This makes it one of the easiest financial assets to trade in.
As a result of the simplicity, a lot of newcomers and traders in the financial markets have found binary trading quite appealing. However, don’t let the simplicity fool you. You must take time, study the market and understand how binary options work so that you can be able to get the most out of your investment. This also means understanding the appropriate markets you can invest in, the right time to enter into a position, the pros and cons of binary options trades and the companies that are licensed to offer binary options trades to US traders.
The structure of binary options from outside the US is not the same as the ones traded in the US exchanges. As a trader, you should fully understand the potential expected outcome when you plan to hedge or speculate on binary options.
Understanding US Binary Options
Using a yes or no proposition, binary options allow investors to trade in markets that have a capped profit potential and capped risk. Take the example of someone investing in gold. You might ask yourself whether the price of gold at 1.30 pm today, will be higher than $1250.
If the trader believes the price will be higher, they can go ahead and purchase the binary option. However, if the trader believes the price will be lower, they can sell the binary option.
Binary options are priced between $0 and $100. Like any other financial instrument, binary options have asked and bid prices.
If at 1 pm, the binary option above is trading at a bid price of $42.50 and an offer price of $44.50, this means that by buying the binary option, the trader will pay $44.50, and if the trader decides to sell, they will sell at $42.50.
If the trader buys the option at $44.50, and at 1.30 pm, the price of gold is more than $1,250. The option will expire, and at that point, it will be valued at $100. The trader, therefore, will make a profit of $55.50 ($100 – $44.50). After accounting for the transaction fees, what they remain with is referred to as being in the money.
Should the price be less than $1,250 at 1.30pm, the option will expire at $0. As a result, the trader will lose the $44.50 that they had invested in the binary option. This is referred to as being out of the money.
Up until the binary option has expired the offer and bid prices will always keep fluctuating. Traders, therefore, are able to close their positions at any given time before the option expires so that they can lock in their profits. If the trader foresees a loss, they can also close the trade before the option expires, so that they can reduce their loss exposure, as opposed to losing the entire investment.
A Zero-Sum Game
In binary options trading, each trade will eventually settle at $0 or $100. If the position turns out to be false, the trade will settle at $0. If the position is true, the trade will settle at $100. What this means is that the potential value of a binary option is $100. Being a zero-sum trade, your loss becomes someone else’s gain, and someone else’s loss becomes your gain.
Every binary options trader puts up capital for their trade to come through. In the example we used above, by buying the option at $44.50, this means that someone else had to sell the option to you. If the option eventually settles at $0, your highest risk exposure is $44.50.
On the other hand, the person who sold you the option has a risk exposure of $55.50 if the option settles at $100. If the trader chooses, they can purchase several contracts.
Let’s give another example, of the NASDAQ US Tech 100 Index > $3,784 at 11 am.
The bid and offer price, respectively are $74.00 and $80.00. In case the trader believes that the index will rise higher than $3,784 at 11 am, they can purchase the option at $80.00. Another idea is to bid lower than $80, in the hope that someone can sell at the offered price.
However, if the trader believes that the index will fall below $3,784 at 11 am, they can choose to sell the option at $74.00, or place an offer that is slightly higher than $74.00, in the hope that someone can purchase it from the trader.
Should the trader sell at $74.00, expecting that the index will fall below the strike price of $3,784 by 11 am, they can choose to buy or sell multiple contracts if they so wish.
How to Bid and Ask Prices Are Determined
Traders try to establish the probability of their expected positions holding, and it is as a result of this that they eventually determine the bid and ask prices. Simply put, in case the ask and bid price on an option are $89 and $85 respectively, the traders expect that there is a high chance that the outcome of the option might be yes, and the option will subsequently expire at $100. In case the bid and ask prices are close to $50, and the traders are not sure whether the binary will expire at $100 or $0, the odds are even.
Assuming that the bid and ask prices are $10 and $15, this is an indication that the traders expect the outcome to be no, and as a result, the option will expire at $0. In such a scenario, the buyers are open to risking a small sum instead of a higher gain. Those who are selling will be making a small profit, which is almost certainly guaranteed, for a big risk.
Where Are Binary Options Traded?
The first legal US exchange specifically for trading in binary options is the Nadex Exchange. Nadex has a unique trading platform that is browser-based, where traders can use either the live account or demo account to familiarize themselves with the platform.
On the Nadex exchange, traders have access to real-time charts, and access to the current prices of binary options in the market.
Apart from the Nadex exchange, traders can also access binary options from the Chicago Board Options Exchange (CBOE). If you have a brokerage account that is approved to trade in options, you can use your normal trading account to trade options. However, you should be aware that not all the brokers you come across offer binary options trading.
It costs $0.90 to enter or exit a Nadex trading contract, with the fees capped at $9. This means that if you choose to purchase 20 contracts, the highest you will pay to enter or exit the position is $9.
Should you choose to hold your trade until it is settled, and you end up in the money, the exit fee is assessed at the expiry of the position. However, should you hold the trade until it is settled, and you end up out of the money, you will not be charged an exit fee.
There are several option brokers through which you can trade your CBOE binary options and each of these charge unique commissions.
Choose Your Binary Market
There are different classes of assets that can be traded through binary options. On Nadex, you can trade in most of the major indices like the Dow 30, Nasdaq 100, S&P 500 and Russell 2000. You also have access to global indices like the Japan 225, Germany 30 and FTSE 100 for the UK.
You can also place trades on different forex pairs like AUD/JPY, AUD/USD. EUR/JPY, GBP/USD and so forth.
Nadex also lists commodity binary options that are pegged on the prices of silver, copper, gold, natural gas, soybeans, corn, and crude oil. You can also trade in news events, speculate on whether the Federal Reserve will raise or lower its rates, whether the nonfarm payrolls or jobless claims will be higher or lower than the current consensus estimates.
There are two binary options that are available for trade on the CBOE; BVZ, a volatility index option that is based on VIX, the CBOE volatility index, and the S&P index from the S&P 500 index.
Choose Your Investment Timeframe
You can choose Nadex binary options in the asset classes above that to expire in different categories, weekly, daily or hourly.
Hourly options are perfect for day traders. This is because they can get returns even when the market is quiet, by predicting the market direction in the stipulated time.
Daily options expire at the close of trading for that day. These are ideal for day traders or investors who want to hedge forex, stock or commodity based on the movement of that day.
Weekly options expire at the close of business for that trading week. These are ideal for swing traders and day traders, especially when the expiry gets closer on Friday in the afternoon.
If you invest in event-based contracts, these expire soon after official news related to that event is released. Therefore, traders in such events will assume a position in the option, up until the event expires.
Advantages and Disadvantages
Forex and stock markets experience slippage and price gaps from time to time, which can be very risky for traders. In the case of binary options trading, however, there is a cap on the traders’ risk exposure. What this means is that it is impossible for the trader to lose more than the value of the trade.
Even in a quiet market scenario, traders can still enjoy some good returns in a binary options market. On the contrary, it is very difficult to make a profit in a stock market or on forex pairs in a quiet or slow market. Besides, you already know the payouts in a binary options market ahead of time.
Say you purchase a binary option at $20. This position can settle at $0 or $100. This means that you can either lose $20 or earn $80 on this investment. Statistically, the 4:1 reward to risk ratio is impossible to be replicated in a stock or forex market.
Given all these positives, one downside to binary options trading is that there is a cap to your expected gains. Binary options can only earn you $100 at most. Forex and stock trades, on the other hand, have infinite possibilities. Perhaps the best way to earn more from binary options would be purchasing several contracts.
There are no day trading limits applicable on binary options trades. Besides, since the maximum you can invest is $100, binary options trades are open even for traders with limited finances. You only need a $100 deposit to trade on Nadex.
Binary options are derivatives traded on underlying assets that the trader does not own. As a result, the trader has no voting rights and earns no dividends, which they would be entitled to if they owned the stock.
You can use binary options as an opportunity to trade in the volatility of the underlying market, by limiting your exposure to risk especially if the underlying market is experiencing a volatile environment.
You can also use binary options to trade in market directions using out of the money strikes. This means that the cost of entry is cheaper. Should the underlying market be higher than you anticipated or expires above the strike price for the buyer, at or below the strike price for the seller, the contract will expire at $100.
There is no limit to your earning potential when you are trading the underlying market. However, with binary options, you have a better alternative for trading with the expectation of a good return and limited risk exposure.
Low Volatility/Flat Market
If the trader has reason to believe that the market will stay flat or trade sideways, they can choose to trade in binary options that are in the money. These are trades that feature low returns and high entry costs because of the capped payout when they expire.
If the market remains flat, the option stays in the money. The contract will expire at $100. If the trader pays $80 for the option, the net profit, exclusive of trading fees upon expiry will be $20.
Trading in binary options is a very simple yes or no scenario. The gains or losses depend on the purchase and selling price, and whether or not the option will expire at $0 or $100. Risk and rewards in binary options trading are capped.
Traders have the opportunity to exit a position before the option expires, either to take a higher profit or to reduce their risk exposure. In the US, binary options are traded through the CBOE and Nadex exchanges. Be very careful because any foreign company that attempts to encourage a US resident to trade in binary options is most probably operating an illegal business.
There is a very low barrier to entry in binary options trade. However, do not let this simplicity fool you. Like any other investment, make sure you are trading with money that you can afford to lose. When you are starting out, use the demo accounts to learn how to trade in binary options before you can start trading with real money.