Binary options may sound complicated, but they’re really not. In fact, they offer traders alternative ways to trade stock indices, commodities and currencies—even economic events.
Say you think the S&P 500 is going to rise, or the U.S. dollar will fall or the monthly unemployment report will be disappointing. Binary options allow you to trade these outcomes with a relatively small amount of money and limited risk.
As the term binary suggests, it’s an all-or-nothing trade. You either gain or lose if you decide to stay in your trade until expiration, although closing a position early, to lock in profit or limit loss, is also an option. Another benefit to trading binary options is at the time you place a trade, your maximum potential loss is known in advance. Additionally, the very nature of binary options is such that they provide trading opportunities in up or down trending, flat and even volatile market conditions.
Binary options give traders a very interesting way to capitalize on trading insights where the risks and payouts are fully known upfront.
How Binary Options Work
In every binary option, there’s a buyer and a seller—just like with any trade. The exchange is simply matching the buyers and sellers on every trade in a regulated environment.
Let’s say you think the price of gold will rise above $1250 by 1:30 pm the next day. You would buy a binary option that would pay off if gold was above $1250 at 1:30pm. Alternatively if you did not think the price of gold would be above $1250 by 1:30 the next day, you would sell that binary option.
When trading binary options, you’re not actually buying a gold futures contract, but simply making a prediction on the trading price level of gold futures at expiration. The initial cost of your binary trade depends on the gold futures price relative to the strike price and time to expiration.
The binary trading price range fluctuates between $0 and $100 and could be thought of as a probability. A binary price approaching 100 would be a high probability trade for the buyer and a very low probability for the seller.
Conversely, the binary price approaching 0 would be the opposite, high probability for the seller and low probability for the buyer. The binary trade price is equivalent to the trade probability for the buyer; the probability for the sell is $100 payout subtracted from the binary trade price.
So, if you think there’s a 40% chance gold will rise above $1250, you can buy a binary options contract for $40. 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.
So in your $40 trade, your maximum profit is $60 and your maximum loss is $40, not inclusive of exchange fees. The opposite is true for the person on the other side of the trade.
In considering the binary price as a probability, any trade price over 50, it could be said that the buyer has a statistical advantage over the seller that the contract will settle at 100. For this advantage, the buyer will be required to put up more collateral to place the trade than the seller. If the trade price is below 50, the seller could be said to have the statistical advantage. At a trade price of exactly 50, the probability as represented by price is exactly the same for both buyer and seller.
The risk/reward ratio of the binary trade is dependent on the amount of this advantage or disadvantage at the time the initial trade was executed.
The Bid/Offer Price
If you look at binary options on Nadex, you’ll see many different contracts with different bid and offer prices and numerous expirations. For example, here is a sample screen shot of Daily Binary Gold contracts. Let’s take a look at the Gold (Feb)> $1249.0 at 1:30 pm priced at 24.50/ 30.00.
The first price--24.50--is the best bid, which is the price that one is willing to buy the binary Gold > $1249.0 at 1:30pm. The buyer of the binary thinks gold (February) futures will finish above $1249.0 at 1:30pm EST expiration.
Binary Trade at 24.50:
Buyer cost: 24.50 (maximum loss)/ maximum potential gain of 75.50 at expiration…. 308% return
Seller cost: 75.50 (maximum loss)/ maximum potential gain of 24.50 at expiration…….32% return
The second price--$30.00--is the best offer, which is the price that one is willing to sell the binary Gold > $1249.0 at 1:30pm. The seller of the binary thinks gold (February) futures will finish at or below $1249.0 at 1:30pm EST expiration. If there is a binary trade at 30.00
Buyer cost: 30.00 (maximum loss)/ maximum potential gain of 70.00 at expiration…. 233% return
Seller cost: 70.00 (maximum loss)/ maximum potential gain of 30.00 at expiration……43% return
All examples above are not inclusive of exchange fees.
The bid/offer prices change throughout the day as the price of gold futures fluctuates above and below the relative strike price levels. The greater this price differential, the more predictable the binary becomes and is priced towards the extremes of either 0 or 100.
It is important to remember the movement in the price of a binary option and the ultimate settlement price, 0 or 100, are determined by the price of the underlying market (February Gold Futures in the example above). As such, when considering buying or selling a binary option, it is important to conduct your analysis based on the underlying market, rather than on the binary option price itself.
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