Binary Options Explained

---

Binary options, if you are not familiar, are based on a simple 'yes' or 'no' proposition: Will the underlying asset be above a certain price at a certain time?

Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal amongst traders and newcomers to the financial markets. But as simple as it may seem, traders still need to understand how binary options work, what markets they can trade with binary options, and which companies are legally authorized to provide binary options to U.S. residents.

Binary options provide a way to trade markets with capped risk and capped profit potential.

For example: Will the price of gold be above $1,150 at 1:30 p.m. today?

If you believe it will be, you buy the binary option. If think gold will be below $1,150 at 1:30 p.m., then you sell this binary option.

The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.

The above binary may be trading at $50 (bid) and $52 (offer) at 1 p.m. As with any other instrument trading with a bid and ask, that means one can buy the contract for $52 or sell it for $50

Let's assume you decide to buy at $52. If at 1:30 p.m. the price of gold is above $1,150, your option expires and it becomes worth $100. You make a profit of $100 - $52 = $48 (less fees). This is called being "in the money."

But if the price of gold is below $1,150 at 1:30 p.m., the option expires at $0. Therefore you lose the $52 invested. This referred to as expiring "out of the money."

The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss (compared to letting it expire out of the money).

Eventually every option settles at $100 or $0; $100 if the binary option proposition is true, and $0 if it turns out to be false. Thus each binary option has a total value potential of $100, and it is a ZERO-SUM GAME – what you make someone else loses, and what you lose someone else makes.

Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $52 and someone sold you that option. Your maximum risk is $52 if the option settles at $0, therefore the trade costs you $52. The person who sold to you has a maximum risk of $48 if the option settles at $100 ($100 - $52 = $48).

Obviously most traders will buy or sell multiple contracts due to the small dollar amount per contract.

Another example: NASDAQ US Tech 100 index > $3,784 (11 a.m.).

The current bid and offer is $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80 (or place a bid at a lower price and hope someone sells to you at that price). If you think the index will be below $3,784 at that time, you sell at $74.00 (or place an offer above that price and hope someone buys it from you).

You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the "strike price") by 11 a.m.

The image below shows a trade to sell five contracts at $74.00. The Nadex platform automatically calculates your maximum loss and gain when you create an order, called a "TICKET."

 

Nadex Trade Ticket with Max Profit and Max Loss

(Source: Nadex.com)

 

The maximum profit on this ticket is $370 ($74 x 5 = $370), and the maximum loss is $130 ($100 - $74 = $26 x 5 = $130) based on five contracts and a sell price of $74.00.

Where to Trade Binary Options

Binary options trade on the Nadex exchange, the first legal U.S. exchange focused on binary options. Nadex provides its own browser-based binary options trading platform which traders can access through a live or demo account.

Binary options are also available through the Chicago Board Options Exchange (CBOE). Anyone with an options-approved brokerage account can trade CBOE binary options through their traditional trading account, but not all brokers offer binary options trading.

Commissions & Fees

Each Nadex contract traded costs $0.90 to enter and $0.90 to exit. The fee is capped at $9, so purchasing 50 contracts (also called "lots") will still only cost $9 to enter and $9 to exit.

If you hold your trade until settlement and finish in the money, the fee to exit is assessed to you at expiration. If at settlement, the trade is out of the money, no trade fee is charged.

Unlike stock, option and futures trading, binary option traders are not charged a commission (other than the 90 cent Nadex fee). But as you probably guessed, binary option brokers aren't just swell guys who let clients trade for free. In order to generate a profit, they adjust the "payout ratio."

It works like this. Let's say a trader purchased a binary option for $50. If it expires in the money, it should be worth $100 like all binary options. Instead, a 90% payout ratio is applied to this potential profit. If the contract does in fact expire in the money, the trader would receive $90 ($100 * 90%) instead of the full $100 value.

Payout ratios vary by broker and it is important to know the rate before engaging in any trading activity since this will directly affect a trader's profitability.

Binary Markets

Multiple asset classes are tradable via binary options. Nadex offers trading in major indices such as the Dow 30 (Wall Street 30), the S&P 500 (US 500), Nasdaq 100 (US TECH 100) and Russell 2000 (US Smallcap 2000). Global indices for the United Kingdom (FTSE 100), Germany (Germany 30) and Japan (Japan 225) are also available.

Trades can be placed on FOREX pairs: EUR/USD, GBP/USD, USD/JPY, EUR/JPY, AUD/USD, USD/CAD, GBP/JPY, USD/CHF, EUR/GBP, as well as AUD/JPY.

Nadex offers commodity binary options related to the price of crude oil, natural gas, gold, silver, copper, corn and soybeans.

Binary options based on news events are even available. Traders can bet on whether the Fed will raise rates or whether jobless claims and nonfarm payrolls will come in above or below consensus estimates.

This may be the closest thing to a Las Vegas roulette wheel accessible from your home computer.

Time Frames

Nadex offers binaries that expire hourly, daily or weekly.

Hourly options provide opportunity for day traders, even in quiet market conditions, to attain an established return if they are correct in choosing the direction of the market over that time frame.

Daily options expire at the end of the trading day, and are useful for day traders or those looking to hedge other stock, forex or commodity holdings against that day's movements.

Weekly options expire at the end of trading week, and are commonly used by swing traders throughout the week.

Event-based contracts expire after the official news release associated with the event, and therefore all types of traders can take positions well in advance of -- and right up to – the expiry.

Advantages and Disadvantages

Unlike the actual stock or forex markets where price gaps or slippage can occur, the risk on binary options is capped. It is not possible to lose more than the cost of the trade.

The flip side of this is that your gain is always capped. No matter how much the underlying asset moves in your favor, the most a binary option can be worth is $100. Purchasing multiple options contracts is the only way to potentially profit more from an expected price move.

Since binary options are worth a maximum of $100, that makes them accessible to traders even with limited trading capital, as traditional stock day trading limits do not apply. Trading can begin with a $100 deposit at Nadex.

Are binary options right for you? Maybe. Personally, I don't touch them. With payout ratios of 60-90%, this eats away even a savvy investor's returns over time. Plus, I don't day trade. I did it for years. I tried every strategy imaginable. Bottom line - I lost money. And so did everyone else I knew that did it.

Are there a handful of talented traders who can make money in the binary option market? I don't know. Probably. But I'm not one of them, and you're probably not either.

Want to make steady returns with binary options? Become a binary options broker.