Many investors may not be familiar with binary options, but they’re actually quite easy to use. And they can play an important role in your investing strategy. Here are some of the more common questions surrounding these options.
What are binary options?
Binary options are a simple yes/no trade in which the trader either gains a fixed profit or loses their original investment. You can buy or sell binary options on stock indices, commodities, currencies and even economic events such as the monthly unemployment report.
How do they work?
Let’s say you think the price of gold will rise above $1250 by 1:30 pm the next day. You can buy a binary option that would pay off if gold is priced above that level when the contract expires. But if you think the price of gold won’t rise above $1250 by 1:30 pm the next day, you can take the opposite position and be the seller of that option.
Unlike regular options, binary options don’t give you the right to buy or sell a particular asset. Instead, they simply allow you to trade on where you think the price of the asset is headed. Binaries only have to be 0.1% in the money for you to gain on the trade.
Binary options also have a time element, in that the trade can last anywhere from a few hours to one week. The length of time is entirely up to you.
How are they priced?
Binary options trade between $0 and $100, which represents the probability that the trade will expire above or below the given strike. A binary near zero, for instance, shows there is little chance the trade will be in the money, while a binary priced near 100 shows a strong possibility.
For instance, a gold contract with a $1250 strike price offered at $40 means there is a 40% probability that gold will finish above $1250. The counter-party to that trade would pay $60 for the contract, predicting that there’s a 60% chance that gold will not rise above $1250.
If you buy the $40 contract and gold does rise above $1250, you are profitable on the trade and collect $60. ($100 payout – original investment) But if gold finishes at or below $1250, you lose your $40 investment to the other party.
Where’s the best place to trade binary options?
Nadex, which is the North American Derivatives Exchange, is the first and largest regulated U.S. exchange for binary options. You can buy and sell binary options there directly without a broker.
Unlike over-the-counter binary options, there is no counter-party risk because Nadex clears and guarantees all trades. Pricing is transparent and all member funds are held in segregated U.S. bank accounts.
Is there a minimum investment?
A trader can open a Nadex account with as little as $100. Exchange fees are $0.90 cents per contract with a $9 maximum per ticket. Because of the capped risk nature of Nadex traded binary options, there is no margin requirement of any kind.
What’s the best way to use binary options?
Because of their all-or-nothing character, binary options are a great way for traders to hedge their portfolios, predict the market’s direction or take advantage of market volatility with limited risk.
Can you give some examples?
Say you want to hedge your portfolio of stocks against a possible downturn. You can sell a binary option that will pay off if the E-mini S&P 500 Index® futures decline below a certain level. So if the market pulls back, your profit from the binary options trade can help offset the losses in your stock portfolio.
You can also just make what is called a directional trade. Say you think the E-mini S&P 500 Index® futures will keep rising, but you’re not sure how much. You can buy a binary option that the underlying will close somewhere above 1750 that day. If it does, you gain on the trade.
Is there any way to exit a position early?
Yes. You don’t have to hold the contract until expiration. You can take your profit or cut your losses early at any time before then.
Where can I find out more about trading binary options?
Nadex.com is a good place to start. It explains in more detail all the different types of binary options and the strategies for using them. You can also set up an account online in minutes.
Futures, options and swaps trading involves risk and may not be appropriate for all investors.