There are many misconceptions about binary options, so it is important that traders understand exactly what they are--and are not--in order to use them effectively.
Here’s a look at some of the more common misconceptions.
Binary Options are Just Gambling
At least on the surface, binary options are structured just like a $100 bet on a football game: You buy the team you like or you sell the team you don’t. A binary is just a simple yes/no trade. The yes trade means you agree with the binary statement—that the market will reach a certain level before expiration, for example—while the no trade means you disagree. The pricing of the binary is between zero and 100 throughout the lifetime of the option.
Unlike football where the underdog will receive odds, the binary has a multitude of strike prices that have a variety of fixed odds.
If you buy a binary priced at 20, there is a low probability of it paying off. Your cost is $20, while your potential profit is $80.
If you sell a binary priced at 20, then there’s a high probability of it paying off. But your cost is $80, while your potential profit is $20.
You can trade binaries on stocks, futures, foreign currency and ETFs as long term investment and or flip them as a speculative short term trade.
Binaries can also be used as a hedge just like standard put options. The difference with binaries is that your potential loss is limited, you can have a very short time horizon and your payout is either all or nothing.
Binary Options May Only Be Bought Not Sold
As you look at the various strike levels of a particular binary option, you’ll see the similarity to call options. As a binary buyer, you’re bullish about the underlying market. The binary at expiration is valued at $100 if underlying market finishes above the strike so the various strike levels will draw similarity to in the money, at the money and out of the money call options as to the relationship of the underlying to binary strike. The at the money binary will be priced around 50 and the pricing is limited to the trading range of zero to 100.
You will not find the binary option chain for the puts. To sell a binary you are taking the opposite view, you’re bearish the underlying market and think it will finish at or below the strike at expiration. So to sell a binary, you go short the binary at the trade price.
Remember that the binary contract is fully collateralized.
AUD/USD >.9140 (3PM) traded at 28
Binary Buyer: is long at 28 trade price and his cost is $28 per contract.
Binary Seller: is short at 28 trade price and his cost is $72 per contract.
Fully Collateralized: buyer cost $28 + seller cost $72 = $100 Expiration payout
You Are Required to Hold Your Position Until Expiration
Binary options are not buy and hold contracts until expiration. At any point prior to the expiration, the binary position can be offset to cut your trading losses or lock in an early trading profit. When you initiate the binary position, your initial trade cost is your maximum exposure, so you’re either long or short the binary at the binary trade price. In a long binary position, you want the price to rally to 100, while in a short binary position you want the binary pricing to sell off to zero.
Binary Options are Not Regulated
Many binary options that are traded over the counter outside of the US are not regulated.
In the US, there are three exchanges, regulated by the CFTC, offering binary options trading, Nadex being the first and largest for retail traders.
Binary Options are Not Transparent
If you are trading binary options on a regulated exchange, you will be provided accurate and up to date time and sales data on all bids, offers and trades throughout the trading session. That's because the exchange is simply matching buyers and sellers on every trade.
Trading Binary Options Requires Enormous Capital
All binary options are priced between $0 and $100 and the minimum amount to open an account with Nadex is $100. Since you are never trading on margin, your account always needs to have sufficient funds to cover the initial cost of the trade plus trading fees.
With binary options, the maximum risk and the potential profit are clearly defined to the terms of the trade assuming a favorable expiration payout. To trade on Nadex, the initial cost is a fraction of the leverage markets on which the Nadex products are based.
As we have seen there are many misconceptions about binary options. We hope we’ve dispelled the most common ones. For more details on the many and varied uses of binary options please visit www.nadex.com
Futures, options and swaps trading involves risk and may not be suitable for all investors.