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A Guide to Trading With Binary Options

Binary options come down to one simple question: Do investors think an underlying asset will end up above or below a price at a set time? Here’s what investors need to know to start trading with binary options.

Key Takeaways:

  • Binary options are financial products that offer a payout (or loss) depending on whether the option expires in the money.
  • Trading with binary options is relatively straightforward, with fixed maximum payouts and clear maximum risks for each trade.
  • Binary options are completely legal, but a relative lack of regulation means investors need to do some research before jumping into these types of trades.

What Are Binary Options?

Image via Unsplash by chronisyan

Binary options are financial products where the investor either receives a payout or loses their investment based on whether that option expires in the money. The name ‘binary’ comes from the fact that the outcome of these types of options depends on a simple ‘yes or no’ proposition.

Every binary option has an expiry date and/or time. Traders need the price of the underlying asset to be on the right side of the option’s strike price at the time of expiry in order to earn money from their trade. Binary options exercise automatically, which means the gain or loss on a trade is automatically credited or debited to the trader’s account when that option expires.

Binary Options vs. Vanilla Options

Vanilla options, commonly just referred to as options, give a buyer potential ownership of an underlying asset. Investors have a fixed risk when buying these types of options, and any potential profits will vary depending on how far an underlying asset’s price moves. Two main types of these options exist:

  1. American options: American options give the investor the right to buy or sell the underlying asset at a set price, either on or before the option’s expiration date.
  2. European options: European options also give the investor the right to buy or sell the underlying asset at a set price, but that investor can only exercise their right on the contract’s expiration date.

Binary options, on the other hand, don’t give an investor the possibility to take a position on an underlying asset. Instead, typical binary options specify a fixed maximum payout. Binary options also limit maximum risk to the amount someone invests in that option.

With binary options, the underlying asset’s movement does not impact the payout the investor receives nor the loss they incur. A trader’s profit or loss simply depends on whether the price of that underlying asset is on the right side of the strike price.

Some binary options allow investors to close before expiration. However, this usually reduces the payout the investor receives if the option is in the money.

There are some binary options trading on platforms that the Securities and Exchange Commission and other agencies regulate. However, the bulk of binary options trading takes place outside of the United States — and it may not be regulated. Since brokers don’t need to meet any particular standard with unregulated binary options, investors should always be wary of potential fraud. Vanilla options, on the flip side, trade on regulated U.S. exchanges and are therefore subject to United States options market regulations.

How Do Binary Options Work?

Let’s look at an example to better understand how binary options work. Say an investor thinks the share price of Company XYZ will be above $50 on a certain date and time. They can buy an option and put $100 on that trade at that given date and time, agreeing to terms of payout for 60%.

If Company XYZ’s shares indeed trade over $50 at that date and time, the trader will get a payout per the terms agreed to. In this case, the binary broker will credit the investor’s account with $60. However, if the price trades under $50 at that date and time, the investor will lose the $100 investment on that trade.

Advantages and Disadvantages of Binary Options

Trading with binary options has a range of advantages and disadvantages.

Advantages

Advantages of binary options include:

  • Control: Investors control the trade with binary options. A trader knows from the start what they can make or lose when entering a trade.
  • Fixed risk: With just a few parameters involved, risk is kept to a minimum. When investors trade other instruments like stock, gold, or oil, they have to contend with a host of factors, ranging from news events to slippage and beyond.
  • Multiple markets: Investors don’t have to be constrained to one market when trading binary options. Indices, bonds, currency — it’s all possible.
  • Potential for profit: Binary options offer attractive returns, with some brokerages offering payouts up to 90%.
  • Simplicity: There’s only one decision with a binary option: the direction. Prices can only move up or down, and the expiry time takes care of when the trade will end.

Disadvantages

As with any type of investment, binary options do come with some risks. Disadvantages of trading with binary options include:

  • Difficulties with risk management: While investors can make smaller trades in other markets, most binary options brokers set a trading floor. That makes it easy to lose capital quickly if even a handful of trades don’t go the way the trader hopes.
  • Limited trading tools: Investors won’t usually have access to advanced analysis and charting for binary options as they would with other financial instruments to inform strategy.
  • Price of losing: Losing trades have higher odds. With any trade, investors could earn around 70% profit but 85% loss, so it’s necessary to get a win percentage of 55% (at least) to just break even.
  • Reduced trading odds: There’s typically a trade-off with binary options. If there are high odds that the binary trade will succeed, there are likely reduced payout odds.

Types of Binary Options

There are a variety of options to choose from. The most popular types include:

  • Up/Down (High/Low): This is the most simple as well as the most prevalent kind of binary option. Traders just have to decide if the price is going to be higher or lower than the current price at the time of expiry.
  • Ladder: Ladder options are similar to up/down trades, but instead of the current strike price, the ladder uses pre-determined levels that are staggered either up or down. Traders usually need a substantial price move, but it’s also possible to get returns exceeding 100% with this kind of binary option. That said, both sides of a trade aren’t always available.
  • In/Out (Range or Boundary): This type of option involves setting a high and low figure. Then, traders make a decision about whether the price will finish outside or within those set boundaries.
  • Touch/No Touch: Levels either higher or lower than the current price are set before a trader enters a position regarding whether or not the price will touch those levels between the time of the trade and expiry. A trader gets a payout as soon as that touch occurs.

Expiry Times of Binary Options

The expiry time of a binary option is the point when a trade is closed and settled.

A touch option is the exception to this, as this type of option hits at a pre-set level before expiry.

Typical expiries for binary options can be as short as 30 seconds or as long as a year. Binary options started out with very short expiries, but considerable demand means traders can now find a wide range of available expiry times. Some brokers might even allow traders to set their own expiry time.

Three main categories of expiries exist:

  1. Short Term/Turbo: These expiries usually include anything under five minutes.
  2. Normal: Normal expiries typically range from five minutes up to the ‘end of day’ expiries, which are options that expire when the local market for an asset closes.
  3. Long Term: Any expiry that goes past the end of the day is typically considered long term. Expiries as long as 12 months exist.

Are Binary Options Actually Legal?

Yes, binary options are legal, even if there are negative associations out there about them. Binary options have gotten something of a negative reputation because some companies do operate scams when trading binary options. That said, most companies operate fairly, so investors just want to exercise caution and do research first if they choose to trade with binary options.

Regulations in certain regions of the world have led to binary options getting withdrawn from the retail market, for example, in the European Union. However, professional traders still can use binary options. Binary options are also legal in places like Australia and India.

Again, the key here for an investor to ensure they’re using a reputable broker when trading binary options, as scams and fraud do exist.

The issue with binary options is not the financial instrument itself, but dishonest marketing and even cybercrime. Unregulated brokers may promise fast cash but operate scams.

When it comes to binary options, it’s not a question of whether these options are good or bad in and of themselves. They’re just another way investors can get in on options trading. Any aspiring binary options trader simply needs to be alert to the dangers that come with this type of trading and do the necessary research to make sure they’re working with a legitimate broker.