Successful Binary Options Trading Explained
So you’ve heard the term, and think you might be interested, but are a little confused as to what this exactly means. Let’s help in the decision making process with a binary options trading guide you can rely on, we will also help you work out if its better to trade the forex market directly.
Binary options are a way of trading price fluctuations in a range of global markets. Before you start binary trading, it is vital to understand about the risks as well as rewards. It is not uncommon for binary options to be misunderstood, as they are very different from other instruments. They offer different payouts, risks, fees, and a completely different liquidity structure and process of investment. The basics, however, are simple to understand. In the spot forex market via the major currency pairs you can just trade on the price movement which could be safer.
We will start this binary options guide with an answer to the most common question raised by those looking to start binary options trading.
What are binary options?
Trading binary options is becoming a very popular form of investment, and is fundamentally investing in the price and volatility of an asset going up or down. When you trade the asset itself, you are trading on price alone. The assets can be individual stocks, indices, commodities such as gold or oil, or foreign exchange rates. Binary options come under the umbrella of exotic options, and the most common binary option is a ‘high/low’ option. It is therefore also known as a fixed-return option. The reason for this is that the option has an expiry date and time, and a strike price which gives you a set return. It allows the investor to trade in the asset whilst containing his/her risk to the volatility surrounding it. The forex market however is less complicated and you can just trade your directional bias not having to worry about thing like time which could be more beneficial.
Let’s give you an example:
Say an investor thinks that shares in British Telecom, Macdonald’s, or any other company is about to rise in value. They could decide to take out a binary option to buy (otherwise known as placing a ‘call’ on) shares in that company. If the price turns out to be higher when the option expires, they could stand to earn a set payout of between 70% and 95% depending on price of the option paid. However, if the price falls, the entire investment will be lost.
When an investor thinks the market will rise, they choose to purchase a ‘call’. If they believe the market will fall, they purchase a ‘put’. To make money on a call, the price has to be higher than the strike price when the option expires. To make money on a put, the price has to be below the strike price. Trading binary options has become very popular because of the clarity it offers investors. As soon as the option is taken, the level of investment, risk, and possible return is clear from the outset. In comparison to trading the underlying, an investor’s losses and gains are without limit, as a volatile market can push aggressively for or against the traded position. When you are buying a binary option, you are also buying volatility, but risks and rewards are contained within the set limits agreed. If you do this in the plain market it could work out better as profits can be left running for some time with no time constraints.
What is the difference between US and foreign binary options
Binary options trading outside the US usually have a fixed payout and risk. They are usually offered by individual binary options brokers, rather than an exchange. A binary options broker makes money from the percentage difference between what is paid out on winning trades and what is collected from losing trades. The options are designed to be kept until expiry and have an all or nothing payout structure, however, there are some exceptions to this rule. Foreign binary options brokers are not allowed to solicit US clients for trading purposes, unless they are registered. The US regulatory bodies responsible for registering binary options brokers include the SEC (Securities and Exchange Commission), or the Commodities Futures Trading Commission (CFTC). These regulatory bodies have warned US investors of the risks involved with using unregulated binary options brokers, and consider many brokers to have questionable operations.
There are a number of options exchanges that operate in the US, including the Chicago Board Options Exchange and Nadex (the North American Derivatives Exchange). The SEC and CFTC regulate these exchanges, and they offer greater protection for investors when compared with over-the-counter markets. Rates are based on market forces, and can be traded at any time. Fluctuating between 1 and 100, the rate is based on the likelihood of an option ending in or out of the money. There is complete transparency and a binary options trader can exit with the loss or profit that is visible on their screen. This applies to entering a contract in the same way. As these options are traded through an exchange, one contract requires both a buyer and a seller. The exchange makes its money by charging an exchange fee, rather than gaining from losses on a binary options trade, as is the case with a binary options broker.
Different types of binary options
Whatever the type of binary option trade it will help to remember that binary means one or the other, as this concept is applied in all the various types of binary option trades.
- Calls vs Puts – We’ve already touched on this particular type, but basically it refers to whether an option is going up or down. This type of trade is also known as up/down, or high/low and involves predicting whether an option’s price will go up or down during the duration of the option, and where it is when the option expires.
- Touch or No Touch – This type refers to whether an investor thinks the price will touch a certain point or not. The value or price is set by the investor, but it can also be set by brokers who offer an ‘Option builder’.
- Double Touch or Double No Touch – This is very similar to the previous type but has two points to deal with
- Range Options – This type is also known as boundary trading or tunnel betting, and refers to whether the price of an option will finish in or out of a price range. Two barriers are set, one of which is higher than the other.
The key components of a binary option trade
There are three key components of a binary option trade, and it is important to understand the differences. The first key ingredient is the expiry time, and refers to the length of time between buying the option contract and when contract period ends. It can vary considerably, from 1 minute to 30 days. On the whole, traders choose to trade in the short term, and this can vary from 60 seconds to 30 minutes. The second ingredient is the strike price. This refers to the price (of the underlying asset) a trade is entered at, and will ultimately determine whether your trade is a winning or losing one. The third feature of a binary options trade is the payout offer. This is the return a binary options broker is offering and is set out and agreed before any money is put at risk.
As mentioned in the earlier sections, the distinction to be made in taking a binary option over a straightforward ‘spot’ position in the underlying, is that the investor is not only looking reflect his view on direction, but also look to benefit in the volatility of that (underlying) asset. This can work for or against the holder of the binary option, though the risks are contained by the defined limits and payouts agreed at the outset.
However, should the price move significantly beyond the price (in either direction), binary options only look to pay out a set price, while the underlying asset price may far exceed the strike price, in which case a basic spot entry into the market would yield a better return in relation to the stop loss order placed on the trade.
Other factors come into play such as those looking to trade the time component, typically with Double No Touches, which look to capture profits from a period of inactivity, but these contracts are usually on a much longer term basis with wider limits and can use up a significant amount of capital.
Indeed, due to the volatility element of options, traders need to judge whether use of their capital at hand is worthwhile tied up in time based contracts.
A brief history of binary options trading
For the general public, the history of binary options started in 2008. This is when it was first introduced as a publicly tradeable asset on the Chicago Board of Exchange (CBOE). However, things weren’t looking very favorable in the world’s financial markets. It started with the collapse of Bear Stearns and Lehman Brothers, that had been triggered by the subprime mortgage crisis in the US. And it wasn’t long before the collapse became global. Investors were forced to look for investments with a lower risk profile. And they found the answer in binary options trading.
Prior to 2008, binary options had been a semi-official investment product, available for banks, institutional and high net-worth investors, via Over-the-Counter markets. Much the same as Forex trading before its deregulation in 1997. Trading binary options started more than 40 years ago, with the freshly created CBOE. The regulatory framework for trading binary options was still evolving, which made trading a little difficult. It evolved over several years into a simple way of trading options, but was still only offered as part of larger contracts, and there was still no separate liquid market for trading binary options.
Everything stayed pretty much the same until 2007. This was when the subprime mortgage crisis began with the collapse of real estate prices. The Options Clearing Committee had been responsible for developing a regulatory framework for trading options, and in 2007 it proposed several changes that led to the status of binary options being elevated. It became a financial asset that could be traded in its own right in the major exchanges. The recommendations of the OCC were accepted by SEC, in 2008, and it became legal for major exchanges to offer binary options as a stand-alone financial instrument that could be traded. In the same year the American Stock Exchange (AMEX) and CBOE also began offering binary options to the general public.
However, processes were still limited and awkward. Traders were forced to purchase contracts on the S&P 500 index, and only call options were available. Nowadays, there is plenty more choice for binary options traders, and with the developments in information technology and associated software, traders can participate wherever they might be. There are a few different ways traders can choose to trade binary options. And there are further developments taking place. Such as the simulated trading and charting tools now offered by the top binary options brokers, allowing traders to undertake technical analysis to aid with their trades.
A lesson in binary options jargon
When entering the world of binary options trading there are a number of special terms it would be helpful to learn. So here are a few of the most common terms you might encounter.
- Call option – Bought by traders who are anticipating an assets rise in value, before the option expires.
- Put option – Bought by traders who are expecting an assets value to fall, before the option expires.
- Underlying instrument – This is the asset on which an option is structured. Stocks, commodities, and currency pairs are all examples of underlying instruments.
- At the money (ATM) – This is when an option’s strike price is the same as the underlying instrument.
- In the money (ITM) – This refers to a profitable position. The ideal situation for a trader to find themselves in. If the strike price is below the underlying futures contract price for a call option, or above the underlying futures contract price for a put option, it is know as being in the money.
- Payout – Percentage return on an investment.
- Digital or Binary Option – This refers to an option with fixed risk and payouts based on a trader’s correct trading decision.
- Strike price – This is the price that is accepted at the outset of a trade, and determines whether a trader is ITM or OTM.
- Option expiry – The date and time when an option expires.
- Early closure – Some binary options brokers offer this option and it refers to closing an option before its expiry.
- Expiry level – This refers to the price of an underlying instrument at the time of the options expiry.
- Market price – The real world price of an underlying financial instrument.
Important considerations for beginners in binary options trading
Now you’ve finished reading our introduction to binary options trading we feel it’s time to recap on some key factors to remember:
- $10 is the minimum trade amount
- The limit of risk is directly related to trade amount
- Binary options trading is pretty risky – Which is why you should only invest what you can afford to lose
- You are only betting on price movements, rather that actually owning an asset
- You can lose all, or a large percentage of trade amount from a losing trade
- Making money in the long term means winning the majority of trades
- The processes and procedures are pretty simple
- There are many different types of binary options, with up/down being the most popular
The concept of binary options trading is really simple, and any risk is limited by the amount you place on each trade. This form of investment is very transparent as the pay-off is clearly stated before the trade is initiated. Winning a binary options trade means you earn a fixed amount of cash based on a desired outcome. There are only two possible outcomes for each and every trade – hence the name ‘binary options’. It does however mean that when your trade idea is correct, your upside gain is limited. Losses are also limited – which is the important part – though disciplined use of stop loss orders, which form the most effective type of risk management, also ensure this. As a new trader or an established one it may be a better idea to trade the forex market directly.
We hope you’ve enjoyed our beginner’s guide to trading binary options, and will keep us as one of your favorites sites to visit. Keep coming back for more interesting, up-to-the-minute and informative tips, hints, and ideas for those who have decided to join the thousands of investors who are currently enjoying the world of binary options.