Should You Be Trading Binary Options?

10/01/2009 12:01 am EST

Focus: OPTIONS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

New investing products appear more and more frequently. Some of these are good innovations, others are bad, and some are bad now but may improve over time as interest grows. In this article, I will cover an example of a product that fits the latter category. The products I am referring to are binary options. These are new to most individuals, but marketing campaigns currently underway are working hard to create awareness among active traders.

Binary options are designed to eliminate a lot of the complexity of traditional vanilla calls and puts. They are called binary options because they are typically "all or nothing" trades. If you buy a binary option, you will either be paid the maximum gain or you will lose your entire investment.

Most binary options currently available are further simplified by only having one strike price. If you buy a binary call and the market closes above the strike price, you will be paid the maximum gain. If the market closes below the strike price, then you will be paid nothing. The reverse is true for binary put options.

Lets take a look at how this works with a simple case study.

1. You feel bullish and decide to buy a binary call option on Apple, Inc (AAPL) that is currently priced at $186 a share. The option costs $100.

2. By the close of market, AAPL has expired above $186 and you are paid $166, which was the maximum payout. That represents a 66% gain within a single day. Sounds pretty good, right? Some binary options may provide an even larger payout.

3. If the market for AAPL had closed below $186, the option would have expired virtually worthless and you would be paid nothing. That means you have lost 100% of your investment.

Although most binary options available right now look like the example above, there are some variations. For example, the binary options offered by CBOE or Nadex have multiple strike prices and expirations available that are longer than a day.

Here are a few more things to keep in mind before trying your hand at binary, or "all or nothing" options trading.

Binaries Are Expensive

Binary options are some of the most expensive trading instruments available to retail traders. The bid/ask spread can be up to 40% or more of the purchase price. This means you have to be right a lot just to overcome the spread. Trading costs can be a killer, and right now, the cost for binary options just seems way too high.

Short-Term Focus

Most short-term traders lose money. Study after study has shown that actively trading in and out of stocks or other assets leads to below-market returns. There is a great deal of random and unpredictable movement in the markets over short time horizons, so if the best you can hope for is 50% accuracy, then you will lose overall with binary options.

Illiquidity

The large spread on binary options can be partially explained by the fact that these are still very illiquid markets. Depending on where you are trading, once you buy a binary option, you may not be able to sell it. You may have no choice but to sit on it until expiration. That is not an ideal situation for any trader wishing to remain flexible as the market changes.

Overall, binary options fall into the "interesting, but not ready for trading" category. Inevitably there will be traders willing to blaze a trail in these option contracts, and it may be worthwhile to watch these markets develop. I think it is likely that eventually, they will be priced fairly enough to make sense for aggressive traders. If you find them attractive yourself, try paper trading them for now.

For more information, watch the video now:

By John Jagerson of LearningMarkets.com.

Related Articles on OPTIONS