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Understanding Binary Options
12/10/2013 8:00 am EST
Binary options are a simple way to trade price fluctuations in multiple global markets, but a trader needs to understand the risks and rewards of these often-misunderstood instruments, says Cory Mitchell of Investopedia.com and VantagePointTrading.com.
Binary options are different from traditional options. If traded, 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.” This article is based on binary options issued outside the US. In June 2013, the US Securities and Exchange Commission warned investors about the potential risks of investing in binary options and charged a Cyprus-based company with selling them illegally to US investors.
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, indices, commodities, and foreign exchange, a binary option can also be called a fixed-return option. 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 market's direction 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 market's direction ends up losing a fixed amount of her/his investment or all of it.
If a trader believes the market is going higher, she/he would purchase a “call.” If the trader believes the market is going lower, she/he would buy a “put.” For a call to make money, the price must be above the strike price at the expiry time. For a put to make money, the price must be below the strike price at the expiry time. The strike price, expiry, payout, and risk are all disclosed at the trade’s outset. 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 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.
Binary Option Example
A trader is watching the market, and based on her/his analysis predicts the market is going higher, except she/he is not sure by how much. The trader decides to buy a (binary) call option on the S&P 500 index. Suppose the index is currently at 1,800 and she/he finds a binary option through a broker that offers this strike price 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, the trader has no problem finding one to buy. She/he finds one that offers a 60% payout if the option expires above the strike price (call option), but if the price is below 1,800 at the expiry time, she/he will lose 90% of the investment.
The trader 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 the broker for specific investment amounts). The trader invests $100 in a call that will expire in 30 minutes. After 30 minutes, the trader will know if she/he has made or lost money. The price at expiry may be the last quoted price, or the (bid+ask)/2. Each broker will specify expiry price rules, and the trader cannot generally cash out or exit the trade before expiration.
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In this case, when the option expired, the last quote on the S&P 500 was 1,802. Therefore, our trader made a $60 profit (or 60% of $100). Had the price finished below 1,800, she/he 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 her/his money back with no profit or loss, although each broker may have different rules as it is an over-the-counter (OTC) market. The broker transfers profits and losses into and out of the trader's account.
The Upside and Downside
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 in favor 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 get rich. 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 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 she/he 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, traders may still find themselves susceptible to unscrupulous practices, even though it is not the norm. Another possible 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. Starting in 2008, some options exchanges such as the Chicago Board Options Exchange (CBOE) began listing binary options. The SEC regulates the CBOE, which offers investors increased protection compared to OTC markets.
The Bottom Line
Binary options are an alternative for speculating or hedging but come with advantages and disadvantages. The positives include a 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 that is always less than the loss on losing trades. Traders who use these instruments need to pay close attention to their individual broker's 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 of the broker's information and be aware of all risks before making trades.
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