When electricity first arrived in the White House in 1891, the high-tech, circular “on-off” electric light switches were so concerning to President Benjamin Harrison that he refused to touch them. The switches offered only two possible positions: the glimmer of indoor electrical lighting with an upward flip “on,” or the natural darkness in its downward “off” position. The switch positions – their only possible places – were binary.
Binary refers to something divisible into only two parts: High/low, on/off, up/down, etc. Examples like these comprise the first half of the forex financial instruments called binary options. You may be familiar with options, a financial instrument related to the price of an underlying asset, such as a commodity, currency, or index. When you buy an option, you are betting on the price direction of that particular commodity, currency, or index.
Taken together, the financial instruments called “binary options” are contracts that allow the buyer to either profit or lose. The outcome is based solely on the predicted direction of a commodity, currency or index within a specific timeframe. The possible result of a binary options trade is simple: You win the trade if you correctly predict the direction of the underlying asset—up or down. Conversely, you lose if you incorrectly predict the course of the asset.
Binary Option Basics
Basics Options are financial instruments called “Contracts for Difference” (CFD) because you gain or lose without ever owning the actual asset.
That is contrary to a more traditional investment where you own a commodity, such as stock in the company. Your profit or loss in binary options trading depends on your ability to correctly predict the answer to a very straightforward question: Will the price of the underlying asset reach above or below a certain point at a specified time? Your payoff in a binary options trade is sometimes referred to as “all-or-none,” since the only possible payoff is a fixed amount (all or none).
The simplicity of trading binary options is appealing to many traders—from inexperienced newcomers to seasoned professions. With a low minimum to open an account and relatively small money outlay for trades, nearly everyone can become binary options traders. That is, you don’t need years of experience and loads of cash to start trading binary options as options traders.
Upfront Risk, Upfront Reward
An attractive feature of binary options is the profit and loss of potential information that is clearly listed before the trade. Your brokerage trading account will show you the maximum profit or loss before you place the trade. This information helps you understand the possible outcome of the trade and enables you to manage your money and risk effectively.
Binary Options Vs. Traditional Options
Binary options differ significantly from traditional options because the latter does not require you to buy or sell the underlying asset. With binary options, however, the trade is profitable only if you correctly predict the price movement of the underlying asset at a particular time. The most you can lose is the price you paid for the binary option.
Profit or Loss: Trading a Binary Option
The three main parts of a binary option are as follows:
- Underlying asset
- Strike price
- Expiration (or “expiry”)
The underlying asset of a binary option is the commodity, index, or currency whose direction you predict. You make or lose money based on the movement of that asset. Take crude oil, for example. The price of crude oil moves direction when market conditions fluctuate. These price variations may include changes in crude oil supply, demand, or world politics. Let’s say a significant source of crude oil experiences political instability that threatens crude oil output. The price of crude oil could then rise from an expected reduction in supply.
Every binary option has a strike price, which is the price you believe the underlying asset will reach before the expiry of the date of expiration. If you predict the direction correctly, you get $100. If you incorrectly predict the course of the underlying asset, you get nothing and lose what you paid for the option. The price of every binary option ranges from $0 to $100.
With every binary options trade, you’ll either profit from your correct prediction of the price movement of the underlying asset, or you’ll lose the price you paid for the binary option.
Time is a fundamental part of every binary options trade. The typical short-term nature of binary options trading is one of its appealing features. They are considered short-term contracts since they last from five minutes to five days. You can select to trade based on your prediction of how the underlying asset will go hourly, daily, or weekly. The expiration, therefore, refers to the date and time a binary option stops trading, that is when the market closes for your particular binary option. Once it reaches expiration, the option no longer trades, and your profit or loss is final.
Win or Lose: Trade Results
The outcome of your binary options trade is either “in the money” or “out of the money.” Your binary options trade is profitable when it is “in the money” or when the strike price is at or above the predicted amount of the binary option. And in the money binary option has a payout based on the terms of your good broker. The flip side of your binary option’s strike price is “out of the money.” Binary options that are out of the money are not profitable and result in a loss of the price you paid for it.
Let’s consider a trade based on the Standard and Poor’s 500 Index, which measures the performance of 500 large company stocks listed on U.S. stock exchanges. When you make this binary options trade on your trading brokers’ trading platform, you’re predicting the direction of the index. It moves when the stock trades that make up the index change in price.
For our scenario, the S&P 500 is currently at 2,850, and you think it will go up to 2,852 in the next hour. For $65, you buy a binary option that expires in one hour. The technical expression of this investment would look something like this: S&P 500 > 2,852 (time one hour from now). This expression says that in the next hour, the S&P 500 will be more than 2,852.
The Profitable Outcome
A profitable outcome of this trade depends on the S&P 500 trading above 2,852 in the next hour. If it does, then you’ll get $100 for the contract when it expires, a profit of $35 ($100-$65), less trading fees. If the S&P 500 index does not reach 2,852 or higher when it expires in the next hour, you get nothing. Your total loss is the price you paid for the option, $65. Remember, all options expire at either $100 or $0. It is important to note that this example is for a single binary option. Your profit or loss could be significantly more if you purchase a larger quantity of options.
No Need to Exercise
Another difference between a traditional option and a binary option is that as a conventional option holder, you do not need to exercise it. To clarify, you hold the right to own the underlying asset for as long as you want. As a binary option contract owner, there is no right to hold an underlying asset. For profitable binary options trades, the money is put into your account automatically. You can then transfer the money out to a savings or checking account.
The Commodity Futures Trading Commission (CFTC) regulates the market for binary options. Its job is to protect market users from market manipulation and fraud. The CFTC requires U.S. forex brokers seeking licensing to undergo a strict demonstration of financial resources and commitment to rules that protect traders. The rules are designed to provide all investors with fair trading conditions.
In the U.S., you can legally trade binary options that are only sold on an exchange regulated by the CFTC. This requirement has not prevented U.S. traders from opening accounts with unregistered binary options trading brokers, however. Since trading is internet-based, you could trade with a broker located anywhere. Binary options brokers are popping up all over the globe.
There have been numerous cases involving fraud by these non-regulated brokers. The U.S. registered binary options brokers are the only binary options brokers legally allowed to permit U.S. citizens with trading access.
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Looking Out for You
The ease of entry into the binary options market for consumers increased the number of binary options brokers. Nearly all are unregistered with a government regulatory agency looking out for the interest of traders like you. Because many of the binary options brokers are unregulated, you only have two choices of regulated binary options brokers:
- The North American Derivatives Exchange or NADEX, which was the first U.S. exchange to offer binary options legally in the U.S.
- The Chicago Board Options Exchange (CBOE)
To find the best binary options broker, stick with the CFTC registered broker.
Safekeeping Your Money
Binary options are in a class of investments called collateralized contracts, so each trade you make will have two sides: the buyer and seller. Both sides have to put the money up for their side in its entirety, which is why a reputable, registered broker is essential.
For example, suppose you believe that the price of silver is going to go up, and its currently trading at $18 per ounce on October 2, 2019, at 10:00 am. You believe that the price will rise to $19.00 by 11:15 am on October 2, 2019. So, you buy a binary option for a $19 strike price contract, selling for $70 bid and $71 offer. (The bid price is the price other buyers are proposing to buy the option. The offer price is what the seller is asking for the option.) You buy the option at $71, the offer price. As the binary options owner, you have until 11:15 am for the price of silver to hit $19 or more to profit.
Maximum Gain If You Won
Your maximum gain for betting the right direction of silver would be $29, while your maximum loss would be $71 (what you paid for the option). Note that the price you paid to the seller, $71 plus the maximum profit of $29 equals $100. When you buy a binary option, the price you pay plus the maximum profit of a winning trade will always be $100. You purchased the option for $71, and the seller pays you $100 at expiration. You keep the difference. In this case, your $29 gross gain from the trade is 40% ($29/$71).
If You Lose
On the other hand, if you lost the trade because the price of silver did not reach $19 by 11:15 am, you’re out the full amount you paid for the option, $71, a 100% loss. The seller of the binary option won the trade by betting against your prediction of the market movement of silver. For their risk of having to pay you if you’re right, they keep the price you paid for an option when you’re wrong.
The simple “yes or no” proposition that you set out to profit from when trading binary options may be an attractive way for you to make money. But your odds will significantly improve if you understand the market conditions before you trade, including the maximum possible profit and loss and finding a reputable, registered broker.
Features of a Binary Options Broker
The outcome of a binary options trade has only two possibilities: make the right decision on the direction of the asset— you win, and make the wrong choice – you lose. But getting to the “right or wrong” decision requires a binary options broker you can rely on to give you the features and benefits specific to your financial needs and objectives.
The burgeoning number of binary options brokers worldwide and the lack of broker regulation has resulted in significant customer losses by fraud. It’s crucial to find the right binary options broker since your interaction with them will affect every trade from pricing to payout. They provide the tools and technology you need to make informed, profitable trades. Brokers also offer demo accounts and educational resources.
A recent article on Internet business strategy stressed the significance of brokerage selection: “Brokerage firms are an important link between traders and financial markets. A person’s trading skills will depend on the reliability and professionalism of the broker.”
The information below will help you understand the features of a reputable binary options broker so you can make an investment that suits your trading needs and objectives.
Types of Binary Options to Trade
Spreading your risk and reward among binary options with different underlying assets can be helpful to maximize profit and minimize loss. A broker provides a meeting place to trade binary options tied commodities, indices, and news events. Commodity options let you trade for price movement in gold, silver, copper, oil, and agricultural products. Options are also available for U.S., Japanese, Canadian, and Euro currency. You can trade options on stock indices, such as the S&P 500, Dow 30, and even on foreign indices for Japanese or German stock markets.
A binary contract costs $0.90 on either side of the trade. So, you’ll pay your broker $0.90 to enter the trade and $0.90 to exit the trade for each option. This fee cannot be higher than $9 for each lot of options you trade. If you buy 12 options and have a winning trade, your maximum fee would cost you $9.00 to get in, $9.00 to exit. On trades that you lose, there is no exit fee.
When selecting a broker, be sure you understand the settlement value or payout, which is the proceeds from a winning trade or the loss from an unprofitable one. You’ll see many online brokers that advertise online binary options varying payouts around 85% to 90%. Fortunately, the binary options broker settlement value is 100% in the U.S., and you only have to pay broker fees.
Remember that the buyer and seller put up the $100 together for each binary option contract. The settlement value should be displayed clearly on the trading platform for you to see before you make the trade. For instance, when you’re the binary options buyer and settle a profitable trade with the seller, you’ll get money from the seller. That is the difference between what you paid for the option and $100. Say you buy an option for $60, the option expires in the money, and you get $40 ($60+$40=$100).
The seller of the $60 option, in this case, loses the $40 they paid out for making the wrong call on the direction of the underlying asset. To recap, the buyer paid out $60 initially and took in $100, resulting in a $40 profit; the seller took in $60 from you and paid out $100 for a $40 loss.
Once you understand binary options, the trading platform is your link to successful, timely, and transparent trades. A binary options broker has a unique, internet-based trading platform. The trading platform shows you your balance, proceeds, and drawings from winning and losing trades. More important, every trade you place will go through the trading platform. Trading platforms connect your account to the options exchange for optimum pricing and quick order placement.
Pricing and trade data on the broker’s trading platform are real-time, which enable you to capitalize on moves in the underlying assets. The platform shows your account balance and trading history. There are also interactive charts and technical indicators to help you make the right to buy/sell decisions. You can even access the trading platform from your computer or mobile device.
Before you place your first trade, you may want to test your abilities at trading the all-or-none binary options. Your broker should offer a practice or demo account. The broker funds an account with $25,000 of virtual money, and it’s only on the screen for you to practice your trading skills. It’s a sound way to see if you can makemoney predicting the direction of an index, currency, or commodity. Plus, you’ll get to test-ride the trading platform. Trading hours for binary options are six days a week, for 23 hours a day. You’ll have ample opportunities to practice and trade should you decide to go “live” with your account.
The practice account is also an excellent way to see how to enter your orders, get an idea of maximum gain and loss, and see price moves of the underlying asset and its effect on the price of your binary options position. Demo accounts will help you decide if trading binary options make sense for you.
The minimum deposit to open a trading account at NADEX is only $250. That is a small opening deposit compared to what you need for stock or commodity brokerage accounts (typically starting in the thousands). You may have theminimum deposit of $250 sitting in a checking or savings account. If you do not have large amounts of investment capital to open a standard option or futures brokerage account, the small minimum deposit is very attractive.
Important question – How do you know what you’re seeing on your broker’s binary options trading platform represents an accurate price? How can you be sure the money is there? Market manipulation by unethical brokerages has cost investors millions. Unlike stock trading, prices of binary options are made by customers that buy and sell the binary option (versus go-betweens in stock trades that set up trades between buyers and sellers). Your broker provides the binary options trading platform or venue for buyers and sellers to meet.
The buyer and seller meeting place is where trading transparency is essential. With a regulated binary options trading broker that holds customer funds in an exclusive, segregated account, you can be assured the contract prices are genuine.
Be a Smart Binary Options Trader
Binary options brokers have an interest in providing you with resources to make you an informed, profitable trader. The more you know about trading and can make the right money-making decisions, the less likely you are to leave the brokerage. That’s a win-win outcome—you’re making money on trades, the broker is making money by providing a trading platform and earning fees from your trading. To help you make the best possible options trading decisions, your broker offers training materials, webinars, and videos to help you understand binary options and options strategies.
Finding the best binary options broker for you involves understanding your objectives and needs, as well as the features and benefits of options trading. Can you predict which direction a currency, index, or commodity price will move? If so, trading binary options may be right for you! Just be sure to find the best binary options broker to help you realize your objectives. Their options trading platform and your knowledge may take your investment returns to the next level.