The Ins and Outs of Binary Options

05/26/2011 7:00 am EST

Focus: OPTIONS

Binary options allow traders to take a simple “yes/no” position on a range of markets and with predefined risk, but it’s crucial to understand the risks and inner workings before trading.

Binary, or digital options, are a simple way to trade price fluctuations in multiple global markets, but traders need to understand the risks and rewards of these often misunderstood instruments.

Binary options are different than traditional options. If trading them, one will find these options have different payouts, fees, and risks, not to mention an entirely different liquidity structure and investment process.

When considering speculating or hedging, binary options are an alternative, but only if the trader fully understands the two potential outcomes of these "exotic” options.

What Are Binary Options?

Binary options are classed as exotic options, yet binaries are extremely simple to use and understand in terms of functionality. Providing access to stocks, indexes, commodities and foreign exchange, the options can also be called a fixed-return option (or FRO).

This is because the option has an expiry date/time and also what is called a strike price. If a trader wagers correctly on the direction of the market and the price at the time of expiry is on the correct side of the strike price, the trader is paid a fixed return regardless of how much the instrument moved.

A trader who wagers incorrectly on the direction of the market ends up losing a fixed amount of their investment, or all of it.

If a trader believes the market is going higher, he would purchase a call, and if the trader believes the market is going lower, he would buy a put. In order for a call to make money, the price must be above the strike price at the time of expiry. In order for a put to make money, the price must be below the strike price at the time of expiry.

The strike price, expiry, payout, and risk are all disclosed at the outset of the trade. The payout and risk may fluctuate as the market moves, since a call that is "in the money" by a great degree stands a good chance of finishing in the money if there is a short time to expiration.

Yet, the payout rate and risk that was locked in by the trader when the trade was taken will stand at expiration. This means different traders, depending on when they enter, may have different payouts.

NEXT: A Binary Option Example

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Binary Option Example

A trader is watching the market, and based on their analysis, predicts the market is going higher, except he/she is not sure by how much.

They decide to buy a (binary) call option on the S&P 500 index. The index is currently at 1105 and she finds a binary option through a broker that offers this strike price and that expires before the end of the day.

Since binary options are available on all sorts of time frames—from minutes to months—and with all sorts of strike prices, she has no problem finding one to buy. The trader finds one that offers a 70% payout if the option expires above the strike price (call option), but if the price is below 1105 at the time of expiry, they will lose 90% of the investment.

Traders can invest almost any amount, although this will vary from broker to broker. Often, there is a minimum, such as $10, and a maximum, such as $10,000 (check with a broker for their investment amounts).

The trader invests $100 in a call that will expire in 30 minutes. When the 30 minutes is up, they will know if money has been made or lost. The price at expiry may be the last quoted price, or the (bid+ask)/2. Each broker will specify their expiry price rules, and the trader cannot generally cash out or exit the trade before expiration.

In this case, when the option expired, the last quote on the S&P 500 was 1107. Therefore, our trader makes a profit of $70 (or 70% of $100). Had the price finished below 1105, they would have lost $90 (or 90% of $100).

If the price had expired exactly on the strike price, it is common for the trader to receive their money back with no profit or loss, although each broker may have different rules, as this is an over-the-counter (OTC) market. Profits and losses are transferred into and out of the trader’s account by the broker.

NEXT: Understand the Benefits and Risks of Binary Options

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The Pros and Cons of Binary Options

There is an upside to these trading instruments, but the upside requires some perspective.

A major advantage is that the risk and reward are known. It does not matter how much the market moves for or against the trader, there are only two outcomes: Win a fixed amount or lose a fixed amount.

Also, there are generally no fees, such as commissions, with these trading instruments (brokers may vary). The options are simple to use and there is only one decision to make: Is the underlying asset going up or down?

There are also no liquidity concerns because the trader never actually owns the underlying asset, and therefore, brokers can offer innumerable strike prices and expiration times/dates, which is attractive to a trader. A final benefit is that a trader can access multiple asset classes in global markets generally anytime a market somewhere in the world is open.

At first glance, it seems like an easy way to trade, yet there is a downside, and one point in particular which violates what is often considered a cardinal trading rule.

The major drawback of binary options is that the reward is always less than the risk. This means a trader must be right a high percentage of the time in order to cover losses. While payout and risk will fluctuate from broker to broker and instrument to instrument, one thing remains constant: Losing trades will cost the trader more than they can make on winning trades.

Another disadvantage is that the OTC markets are unregulated, and there is little oversight in the case of a trade discrepancy. While brokers often use a large external source for their quotes, a trader may still find him or herself susceptible to unscrupulous practices, even though it is not the norm.

What may also be of concern is that no underlying asset is owned; it is simply a wager on an underlying asset’s direction.

The money invested cannot be withdrawn nor the trade exited until the expiry time/date. However, starting in 2008, some options exchanges such as the Chicago Board Options Exchange (CBOE) began listing binary options. The CBOE is regulated by the Securities and Exchange Commission (SEC), and so it offers investors increased protection as compared to OTC markets.

Conclusion

Binary options are an alternative for speculating or hedging, but they come with advantages and disadvantages.

The positives include known risk and reward, no commissions, innumerable strike prices and expiry dates, access to multiple asset classes in global markets and customizable investment amounts.

The negatives include non-ownership of any asset, little regulatory oversight, and a winning payout which is always less than the loss on losing trades.

Traders who use these instruments need to pay close attention to their individual brokers’ rules, especially regarding payouts and risks, how expiry prices are calculated, and what happens if the option expires directly on the strike price.

Traders should read through all the brokers' information and be aware of all risks before making trades.

By Cory Mitchell of VantagePointTrading.com

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