Make Binary Options Work for You

07/28/2011 6:00 am EST

Focus: OPTIONS

Binary options are rapidly growing and give short-term traders a flexible, easy-to-use vehicle for their investment arsenal. Let’s examine what these instruments are and the benefits they offer to traders.

With time frames anywhere from an hour to a week in most cases, binary options are very short-term trading propositions. They settle in cash, not in the underlying stock or commodity, and new hourly (or multiple-hour) options are constantly being created and traded throughout the trading day.

Binaries are basically "yes-or-no" trades, i.e., will a certain index/future/commodity close above or below a certain strike price at the expiration date? Generally, the retail available option will be worth $100 if it expires in the money (ITM), and $0 if it expires out of the money (OTM).

Binary options do not have to be held through expiration, however, and they can be bought/sold (both to open and to close/exit positions) any time during trading hours, based on where the bid/ask on the option is at the time.

These options can be opened as either a long or short position. 

See related: The Ins and Outs of Binary Options

For example, if an option is bid 30, ask 35, a trader could buy a long position (generally at the offer of 35), looking to make a gain of $65 based on a maximum closing value of $100 (for a 185% return on risk, not including commissions). 

On the flip side, a trader could sell the option (in this theoretical example for $30), looking for the option to expire worthless at $0. That would be a $30 gain on risk of $70 (for a 42% gain, not including commissions).

But as we mentioned, these options do not necessarily have to be held through expiration. So if you have bought an option for $35 and the current market goes up to $45, you could, in this example, sell it for $45 to close your position. That would be a gain of 28%, not including commissions.

One key idea to note here is that your risk (and hence cash/margin requirement) on these $100 binary option trades is only either the cash premium paid or the difference between the max value and the premium received. 

So in the example above, buying the option for $35, your max risk and cash required is only that amount. And selling it for $30, your max risk and cash required to place the trade would be $70.  The defined and limited nature of the risk allows "short" positions to be placed for relatively low cash outlays and reserves.

NEXT: See a Sample Range of Binary Options Available for Gold

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Let’s look at gold as a theoretical example of the variety of binary options available at a given moment in time:

With August gold’s spot price around $1545 at 10:20 am, the following binary options could be available on gold (August):

Expiring in less than one hour - 11 am:

Gold (Aug) > 1541.90; Bid 74, Ask 80

Gold > 1536.90; Bid 96, Ask N/A

Expiring in less than two hours - 12 pm:

Gold > 1549.60; Bid 10, Offer 15

Gold > 1544.60; Bid 40.5, Offer 47.5

Gold > 1539.60; Bid 78.5, Offer 83.5

Daily Expiring - 1:30 pm:

Markets in many strike prices ranging from:

Gold > 1531; Bid 93, Ask 98

to…

Gold > 1555; Bid 0.5, Ask 4.5

Weekly Expiring - Friday Expiration at 1:30 pm:

Markets in many strike prices ranging from:

Gold > 1497.50; Bid 93, Ask 98

to…

Gold > 1587.50; Bid 1, Ask 5.5

So there are a vast amount of options available for trading gold at any given moment. The at-the-money (ATM) options will generally be in the 50 range (40-60), giving a 50/50 chance of expiring in the money. 

The options that are deep in the money will likely be in the 70-100 range, for example, while options that are far out of the money will likely be in the 30-0 range. Remember that these will expire either for maximum value of 100 ($100) or worthless for 0 ($0), and they can be both bought and sold to open a position.

If you look at the theoretical example above where gold (Aug) is at $1545 and the Gold (Aug) > 1541.90 option expiring at 11 am (less than one hour) is 74.0 by 80.0, then a trader could buy this option for $80 per contract, banking on gold to stay above $1541.90 through expiration so that the option will expire for max value of $100. 

This would give a quick gain of 25% (not including commissions). The trade will reach max value if gold rises in this time frame, if it stays flat, or even if it drops by less than three points (this example has a cushion of three points to the downside). 

If gold does drop below $1541.90 and closes below there, the trader will lose the entire $80 in this example (100% loss), but remember that the trade can also be closed down early depending on where the bid/ask prices are. 

That is just one example of a trading style that can be utilized on binary options. One could look at the bid/ask on a binary option as being similar to a Delta, or probability of the option expiring in the money at that moment in time. Hence, these can be used in many different manners, such as buying high-probability, in-the-money options (and also selling lower-Delta, out-of-the-money options), but also buying cheaper options looking for big directional gains. 

For example, with options in the 40 to 60 range (what we could say are "50/50" propositions), a trader who has good short-term directional indicators/systems could target quick profits in the 100% range with a move in his/her direction. 

Depending on your trading style and risk/reward preference, these vehicles can be tailored to virtually any trading style.

See related: Basics of Binary Options Trading

Another way to think of binary options is to compare them to trading normal options on (or approaching) expiration day, when the “rubber meets the road,” and pricing will generally go to 100% intrinsic value or 0. By trading vehicles that always have a two-hour or daily time frame available, much of the time premium is eliminated and they can become more of a pure probability play. 

NEXT: Discover 5 Key Benefits of Binary Options

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5 Key Benefits of Binary Options

Very Quick Time Frames: You can make intraday trades on a variety of stock indexes, commodities, forex currency pairs, and even economic and other events. Time frames can generally range from less than an hour to a week on binary options, which can be beneficial for those using short-term charts and trading indicators.

Additionally, the time premium in the options will generally be less than that of a longer-term-time-frame option.

Low Margin Requirements/Cash Outlay: Based on the $100 binary options, trades can be made both in long and short directions for a small amount of funds per contract. With growing margins in many futures recently (many require thousands per futures contract), this is a big advantage to the smaller trader.

Cash Settlement, No Risk of Exercise or Delivery: These options expire into either maximum cash value or zero. There is no risk of early exercise/assignment and no physical delivery of underlying stock, currency, or commodity.

Wide Variety of Trading Vehicles: A binary options trading account will normally offer the trader the ability to trade instruments based on the major stock indexes, currency pairs, commodities (gold, oil, silver, etc), and more, all in one location and on one trading platform. This eliminates the need to have separate accounts for futures trading, forex trading, stock index option trading, etc.

Accounts Can Be Opened Quickly Online: Binary option trading platforms often offer the ability to open, fund, and trade an account quickly and in a matter of minutes online. Withdrawals similarly can be done electronically for rapid transfers of your funds.

Bottom line is that binary option trading may be an attractive platform for short-term traders with the proper risk/reward profile. These options offer quick, “yes-or-no” trades with low margin requirements and an immediate cash settlement.

In a future article, we’ll examine another growing area of trading in the binary options field, known as bull spreads.

By the Staff at BigTrends.com

Learn more about binary options and bull spreads in the Options Center

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