Binary or digital 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. Binary options are different than 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”.
TUTORIAL: Options Basics
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 her investment or all of it.
If a trader believes the market is going higher, he would purchase a “call”. If the trader believes the market is going lower, she 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 pay rate out 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 pay outs.
Binary Option Example
A trader is watching the market and based on their analysis predicts the market is going higher, except she is not sure by how much. She decides to buy a (binary) call option on the SP 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. She 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 she will lose 90% of her investment.
She can invest almost any amount she wishes, 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, she will know if she has made money 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 SP 500 was 1107. Therefore, our trader makes a profit of $70 (or 70% of $100). Had the price finished below 1105, she 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 it is an over the counter (OTC) market. Profits and losses are transferred into and out of the traders account by the broker.
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