Investing > What Are Binary Options

What Are Binary Options

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Clarity is the most distinguishing attribute of binary options. When you trade in binary options, it is crystal clear you are getting one of two outcomes: either a fixed, predetermined payoff or nothing at all.

A binary connotes an either-or proposition; likewise binary options are open contracts based upon a simple yes or no question, with a favorable or losing outcome depending on the position taken by the trader.

Binary options provide clear-cut outcomes that don’t leave you in the dark as to what you’re expecting to receive. The remarkable thing that flows from this clarity of unmistaken outcomes is a transparency of well-defined risks because you either win, or you lose on each transaction. 

Seasoned investors know that almost as important as the profits on any given trade, is the risk management applied on every single trade. To survive in the topsy-turvy world of online trading, it is critical to limit risks, especially when trading in volatile markets that have a lot of price movements.

No matter what happens while your binary options trade is occurring: cataclysmic natural disasters, geopolitical tensions, stock market crashes, or a global health pandemic ravaging the world – whatever the case, the trader cannot lose more than was invested in the transaction.

Therefore, the peace of mind and stability of knowing that your risks are also limited and defined 100% upfront is more than enough reason for a trader to delve into binary options. 

However, binary options have garnered some blowback as being similar to gambling, attracting fraud, scams, and other rigged conditions. This article will address the role that regulation plays in ensuring that wholesome practices are fostered in its trading markets.

But before you jump headfirst into binary options, it would, therefore, behoove you as an investor to learn as much as possible about the investment instrument before you delve into it. 

The primary role of this piece is, therefore, to provide the foundational knowledge for our readers to make an informed decision. 

Since knowledge is recursive and self-reinforcing, if you want to know more about options on which binary contracts are based, we have written about them extensively here and here.

What ExactlyAre Binary Options?

We have already hinted at some of the core tenets of binary options in the introduction, but more specificity is still required. Binary options are financial instruments, specifically a form of option contract that is generally built around the commodities’ market but not exclusively so.

Binary options are based upon a simple yes or no question regarding an underlying asset, usually, posed like this: will this particular market be above this price at this foreseeable time in the future? Stated another way: is the underlying asset going to be above a certain price at a particular date and time.

Depending on whether the trader was able to predict correctly, they will receive either one or two stark payoff options: a fixed amount or nothing at all. This simplicity makes binary options one of the easiest financial instruments to trade. Investors can just place trades based on a straightforward premise that doesn’t involve a lot of complications.

However, while the premise is straightforward, there are several terms a trader must get acquainted with in order to successfully participate in options trading.

These are the basic elements that constitute a binary options transaction:

  • The strike price is the predetermined price at which the option will execute. This is the targeted price of the trader for the underlying asset. It is the agreed-upon price at which the option holder might buy or sell the asset when it expires.
  • The current price is the price that the underlying asset is currently available in the market. While this is self-explanatory, it requires emphasis because the current price and the strike price happen to be the two most important factors in determining the payoff for the binary option contract.
  • The underlying asset is the security whose price the binary option contract is based on.
  • There is a certain preset date and time allotted after which the contract will expire. This is known as the expiration or time to expiry of the binary option contract. U.S. options tend to be more flexible with the expiration date, giving traders the freedom to exit the trade at any point in time before it expires. In Europe, however, traders are restricted to only the expiration time as the only time they buy or sell the option.
  • Expiration price is the price the underlying asset attains when the binary option executes
  • The position a trader takes on a binary option depends on whether they are buying or selling the contract.  If they are buying, then they’ll profit when the asset attains or rises above the strike price at expiration. But the trader is selling the binary option, they profit when the current price of the asset is below the strike price.
  • The bid/ask spread, also known as bid/offer, and represents the price at which you can sell and buy a given binary option respectively. When a binary option has a bid/ask price of $50/$50, it simply means that the market has no idea how this contract will resolve. 

When there is a higher signal that the market thinks it is more likely the contract will close in the money (ITM). Conversely, a lower one means it is likely to close out of the money (OTM).

How Do Binary Options Work?

As we stated earlier, binary options present a trader with only a single position to take. Like a betting game, you have to decide whether the price of a specific underlying asset will appreciate or not before a certain period of time.

Since binary options have been equated with flipping a coin or betting on a game, an illustration of how it works with a simple game illustration seems appropriate. 

Assuming there’s a coin that is to be flipped at a specific time, let’s say at 3:00 pm. On the day of the coin flip, participants are invited in the morning to place bets to guess whether the coin will turn up heads or tails when it is eventually flipped. 

For the opportunity to place a bet, participants are charged $20 a pop. Now, the participants are allowed to place as many bets as they want leading up to the time before the coin is flipped at 3:00 pm. 

When the coin is eventually tossed, the owner of every bet that got the outcome right is paid $100 per successful bet. Conversely, nothing is paid for every bet that got the outcome wrong. 

Apart from some minor details here and there, this is essentially how binary options work.

Now, there are two sides to the binary options transaction. The traders who buy the binary option are taking an affirmative position, betting that yes, the underlying asset will equal or rise above a given price (the strike price) by a particular time. 

On the opposite side of the equation, the traders who sell a binary option are taking the contrary position: they are staking the claim that no, the price of the same underlying asset will fall below the strike price instead by the time the given period has expired. The time duration before a binary option can expire varies greatly, with some turnarounds being as quick as 60 seconds.

Binary options are consistent in the amount they payout: either $100 or $0. A binary option is considered to be in the money (ITM) if when the contract expires, the asset’s price is the same as or has risen above the contract’s strike price. 

If so, it pays the $100 to the buyer of the binary option. However, if they predicted wrongly, the binary contract is considered to be out of the money (OTM) and pays nothing. 

The steps below represent the general overview guide on placing a binary trade:

  1. The initial step is to choose a broker. Luckily for our readers, we have already compiled a list of some of the best brokers for options trading.
  2. Then pick the event or asset you want to trade on. Each asset or security is based on a specific market, and the trade you’ll make are subsequently based on the underlying markets price movement. The Nadex market provides commodity binary options based on the price of gold, silver, natural gas, crude oil, soya beans, copper, and corn.
  3. Pick an option time frame. This is often based on the market selected to trade the binary options. Nadex binary options have hourly, daily, or weekly time frames.
  4. Select the size of the trade; but remember that 100% of your investment is at stake so choose carefully.
  5. Choose a strike price that you are comfortable with and that works for you. The strike price is the level you anticipate the market will move above or under.

There are other facets of how binary options, but instead of explaining technical jargon, another illustration should suffice:

Binary options are based on posing questions about the fluctuation of a security. For hypothetical purposes, let’s assume this question was posed: will the price of crude oil trade above $150 per barrel by 2:30 p.m. today?

Based on this question, traders will now place their bets. 

The profit a trader makes on a binary contract depends on the position they take. Traders who buy a binary contract are taking an affirmative position that the price of the underlying asset will meet or rise above the strike price. If they’re proven correct, the trader will receive the $100 

Conversely, traders who sell contracts are taking the position that the underlying asset will instead be below the strike price. 

Just like in any financial market, there is a bid and ask price. 

The crude oil binary may be trading at $54.50 (bid) and $56.50 (offer) by 2:00 p.m. That means that its market price is $54.50/$56.50 (the bid-ask spread), and shows that the market has high confidence this binary contract will expire in the money.

Respectively, the bid/ask spread represents the price at which the market is willing to buy a contract from a trader, and the price it is willing to sell to a trader.

If a trader buys the option at that point, they’ll pay $56.50. Conversely, if a trader decides to sell the binary option right then, they’ll do it for $54.50.

Assume a trader believes that crude oil will be above $150 at the time of expiry and therefore buys the option (the traders position). 

If the buyer is right, and the current price of crude oil is greater or equal to the strike price at 2:30 p.m. they’ll receive a net profit payout of $43.50. This amount results from subtracting the $56.50 offer price paid from the $100 commission received for the betting correctly on the option contract.

If the trader who bought the option is wrong, they’ll only lose the $56.50 offer price paid. 

What Are the Differences Between Binary Options and Traditional Options

Binary option have a lot of similarities with other traditional options – which shouldn’t come as a surprise since option contracts share various commonalities. 

The difference between binary options and other options (otherwise known as vanilla options) is the payoff structure when the binary option expires. As we have learned so far, when a binary option expires, then are only one of two outcomes: the trader either gets a $0 or $100 payout.

However, with traditional, vanilla options, the payout is obtained by subtracting the current price of the underlying asset at expiration from the strike price of the option.

How to Trade Binary Options in the USA

There are differences between trading binary options in the U.S. and outside its shores. Binary options are only available and legal to trade in the U.S. on exchanges regulated by Commodity Futures Trading Commission (CFTC). 

The CFTC oversees options, futures, and swaps in the U.S. trading market. CFTC is part of a U.S. government agency and it has the mission to protect both the public and market users from abuse, fraud, manipulation and other systemic risks. 

CFTC views binary trading through the same lens as gambling. Therefore, it has enacted sanctions and legislations akin to those that regulate casinos. Furthermore, this dim view of binary options has resulted in the CFTC forbidding international companies from soliciting US traders or advertising their services. 

As a result, it is difficult  to find international brokers that accept US traders, and this limited choice means that US residents have to find local brokers. The effect of all these barriers is that U.S. traders now increasingly find themselves without a reliable broker.

Binary options are traded through the CBOE and Nadex exchanges within the U.S. 

How to Trade Binary Options Outside the U.S.

Binary options aren’t as generally regulated like other traditional such as Forex trading. In many of these countries, binary options are traded over the counter without any government oversight. 

As a result, there are abundant online binary option brokers, especially for those residing outside the United States. However, this proliferation means traders need to proceed with caution and ensure they are dealing with reputable firms.

The good news is that while the United States has entrenched ample protection for traders and users to ensure that fraud and abuse is reduced in the binary options market, other countries,  though initially slow in responding, have started to make their presence felt.

These are notable regulators in other parts of the globe that are making sure binary options trading markets are a safe place for traders to place their bets: 

  • For those residing in the UK, the regulator is the Financial Conduct Authority (FCA) 
  • For those living in Australia, the Australian Securities and Investments Commission (ASIC)
  • The regulator responsible for the Republic of Cyprus is the Cyprus Securities and Exchange Commission (CySec), which is often usually “passported” throughout the EU through Markets in Financial Instruments Directive (MiFID)

The interest binary options is drawing, especially from authorities in Europe, is bound to bolster domestic regulations around the world.

Outside of the United States, most binary options are typically offered by individual brokers rather than by exchanges. They normally have fixed payouts and risks.

How Safe Is It to Trade Binary Options?

Despite its plain simplicity, binary options have drawn a lot of scrutiny as one of the most polarizing types of investments. Some in the investment community deride them as nothing more than gambling because of the all or nothing proposition they present in their transactions.

Like gambling, binary options are structured like bets placed on sporting activity. For example, you either bet that a football team or racehorse will win or not; which isn’t too dissimilar to a simple yes or no binary trade proposition. That is why they are considered to be risky financial instruments. 

However, unlike in sports betting where the underdog will receive odds, a binary option provides a multitude of strike prices (this will be explained later) which have a variety of fixed odds. Moreover, there are third parties involved in binary options payments, so it isn’t as if the trader is only betting against the house like a gambler in a casino.

The safety and regulation of binary options often go hand-in-hand. Without regulation, all market participants can’t be expected to be scrupulous actors.

Therefore, robust and active regulators play a huge role in ensuring the safety of binary options in their local markets. In the preceding sections, we have highlighted some regulators. However, many unregulated brokers are still allowed to operate.

Although some of these brokers might be trustworthy, you should nonetheless consider a lack of regulation as a red flag that makes you proceed with caution at the very least. It is your responsibility to do your research to ensure you are dealing with a legitimate provider.

When you trade options on a regulated exchange, you will be able to witness how the exchange is matching buyers and sellers on every trade. At your disposal will be up-to-date and accurate sales data on all the offers and bids. This occurs throughout the duration of the trading session, so you are not left in the dark as to what is happening.

If you live in the United States, you are amply covered by the CFTC, which provides a lot of oversight. As of this writing, only three exchanges are regulated by the CFTC, and the largest for retail traders is Nadex.

What Are the Advantages of Using Binary Options?

There is minimal confusion with binary options because they are transparent, providing clearly defined risks and outcomes on each trade. Each binary option trade is relatively easy to understand because, for the most part, they reflect the way people normally think and evaluate choices about things in their daily life. 

The risk associated with binary options is capped; therefore, you can’t lose more than the cost of the trade. This is unlike forex markets or actual stock where slippage or price gaps can occur.

It is difficult to profit when the market is barely moving, but a binary option defies some of these market laws because of the way it is structured. During periods when the market is very quiet, above-average returns are still possible with binary options.

For instance, the payout of a binary option is already known in advance. Whether you purchase a binary option at $25 or any other amount, the payout will always settle at $100 or $0. In this example, the trader will make a profit of $75 on a $25 investment; or lose everything if they predicted wrong.

This evaluates to a reward to risk ratio of 3:1, an exceptional opportunity that isn’t likely to materialize in the actual market which underlines the binary option. 

In addition, binary options are worth a maximum of $100, and are relatively cheap. Therefore, they are available to traders with limited capital. Moreover, stock trading limits don’t apply with binary options. 

Summary of Binary Option Pros

  • Risks are capped, so there is a limit to the amount of money a trader can lose. 
  • It provides better than average returns, especially during a slow or quiet market
  • Payouts are transparent and known in advance
  • Binary options are relatively straightforward and easy to understand
  • You can exit the binary option trade at any time before its expiry either to minimize losses or lock in profits

What Are the Disadvantages of Binary Options

While the risk of binary options is capped, the downside is that the gains are also equally  capped. So, no matter how much the stock or forex market is bullish and moves favorably in your direction, the most the binary option can reward you is $100.

To circumvent this cap, one way traders potentially try to take advantage and profit from an expected prize move is to purchase multiple binary option contracts. 

You don’t own binary options because they are derivatives based on an underlying asset. As a result, the trader who buys them isn’t entitled to any dividends or voting rights. 

Summary of Binary Option Cons

  • Because they are derivative-based, binary options can be volatile
  • Due to U.S. laws and regulations, there are a limited choice of binary options available for its residents
  • This has resulted in limited array of binary option choices for those residing in the U.S.
  • No matter how favorable market conditions are, the binary option gains are capped

Key Takeaways

  • Binary options are based upon a derivative not owned by the trader
  • Binary options are relatively simple and come with a fixed payout or nothing at all while relying on a yes or no proposition.
  • Binary options have both the potential and possibility of capped potential and risk.
  • Since exchange traded binaries have now become available, traders are no longer trading against the broker.
  • Since the outcome is always either a yes or no, binary options make both risk management and trading decisions much more simplified. 
  • A binary transactions bid and ask prices are established by the traders themselves, because they asses and evaluate whether the probability set forth is true or not
  • In binary trading, you can choose to close a position early in order to limit losses or lock in profits
  • Outside the U.S., binary options are used as an alternative to hedging or speculation

Conclusion

If you have ever wanted to make money by flipping a coin, then binary options are the closest you’ll ever find to fulfill the fantasy.

However, one might legitimately ask why, with all the investment vehicles already available such as stocks, exchange-traded funds, futures, and forex, would anyone need to add another contract to their trading repertoire?

A litany of answers to that question has already been addressed including risk management and simplicity, but we’ll close with a few more pertinent to rookie traders.

Binary options are simple to understand, making them an ideal and popular choice for new and low-skilled traders. More safeguards afforded to the novice investor comes in the form of providing full transparency at all times, equipping traders with the ability to cut their losses or take their profits prior to the contracts expiration in the U.S.

To profit from price fluctuations, especially in multiple global markets, binary trading options are used. 

This is because binary options allow traders to take advantage of the market as rate fluctuates. They can do this by either taking advantage of varying risk-to-reward scenarios. Alternatively, they can simply decide to wait until the contract expiration, thereby closing with the maximum gain or loss.

This flexibility offers the binary options trader the opportunity to profit from even small market movements. 

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on TheTokenist.io. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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