Binary options are based on a simple 'yes' or 'no' proposition: Will an underlying asset be above a certain price at a certain time? Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal amongst traders and newcomers to the financial markets. As simple as it may seem, traders should fully understand how binary options work, what markets and time frames they can trade with binary options, advantages and disadvantages of these products, and which companies are legally authorized to provide binary options to U.S. residents.
Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative, but only if the trader fully understands the two potential outcomes of these "exotic options." (For related reading, see: What You Need To Know About Binary Options Outside The U.S.)
U.S. Binary Options Explained
Binary options provide a way to trade markets with capped risk and capped profit potential, based on a 'yes' or 'no' proposition.
For example: Will the price of gold be above $1,250 at 1:30 p.m. today?
If you believe it will be, you buy the binary option. If think gold will be below $1,250 at 1:30 p.m., then you sell this binary option.
The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.
The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then you will pay $44.50, if you decide to sell right then you'll sell at $42.50.
Let's assume you decide to buy at $44.50. If at 1:30 p.m. the the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100 - $44.50 = $55.50 (less fees). This is called being "in the money."
But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This called "out of the money."
The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss (compared to letting it expire out of the money).
A Zero-sum Game
Eventually every option settles at $100 or $0; $100 if the binary option proposition is true, and $0 if it turns out to be false. Thus each binary option has a total value potential of $100, and it is a zero-sum game – what you make someone else loses, and what you lose someone else makes.
Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, therefore the trade costs you $44.50. The person who sold to you has a maximum risk of $55.50 if the option settles at $100 ($100 - $44.50 = $55.50).
A trader may purchase multiple contracts, if desired.
Another example: NASDAQ US Tech 100 index > $3,784 (11 a.m.).
The current bid and offer is $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80 (or place a bid at a lower price and hope someone sells to you at that price). If you the think the index will be below $3,784 at that time, you sell at $74.00 (or place an offer above that price and hope someone buys it from you).
You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the "strike price") by 11 a.m. And if you really like the trade, you can sell (or buy) multiple contracts.
Nadex Trade Ticket with Max Profit and Max Loss (Figure 1)
The maximum profit on this ticket is $370 ($74 x 5 = $370), and the maximum loss is $130 ($100 - $74 = $26 x 5 = $130) based on five contracts and a sell price of $74.00. (For more on this topic, see Introduction To Binary Options)
How the Bid and Ask are Determined
The bid and ask are determined by traders themselves as they assess the probability of the proposition being true or not. In simple terms, if the bid and ask on a binary option are at 85 and 89, respectively, then traders are assuming a very high probability that the outcome of the binary option will be 'yes,' and option will expire worth $100. If the bid and ask are near 50, traders are unsure if the binary will expire at $0 or $100 – it's even odds.
If the bid and ask are at 10 and 15, respectively, that indicates traders think there is a high likelihood the option outcome will be 'no,' and expire worth $0. The buyers in this area are willing take the small risk for a big gain. While those selling are willing to take a small – but very likely – profit for a large risk (relative to their gain).
Where to Trade Binary Options
Binary options trade on the Nadex exchange, the first legal U.S. exchange focused on binary options. Nadex provides its own browser-based binary options trading platform which traders can access via demo account or live account. The trading platform provides real-time charts along with direct market access to current binary option prices.
Binary options are also available through the Chicago Board Options Exchange (CBOE). Anyone with an options-approved brokerage account can trade CBOE binary options through their traditional trading account. Not all brokers provide binary options trading, however.
Each Nadex contract traded costs $0.90 to enter and $0.90 to exit. The fee is capped at $9, so purchasing 15 lots will still only cost $9 to enter and $9 to exit.
If you hold your trade until settlement and finish in the money, the fee to exit is assessed to you at expiry.
If you hold the trade until settlement, but finish out of the money, no trade fee to exit is assessed.
CBOE binary options are traded through various option brokers; each charge their own commission fee.
Pick Your Binary Market
Multiple asset classes are tradable via binary option. Nadex offers trading in major indices such as the Dow 30 (Wall Street 30), the S&P 500 (US 500), Nasdaq 100 (US TECH 100) and Russell 2000 (US Smallcap 2000). Global indices for the United Kingdom (FTSE 100), Germany (Germany 30) and Japan (Japan 225) are also available.
Trades can be placed on forex pairs: EUR/USD, GBP/USD, USD/JPY, EUR/JPY, AUD/USD, USD/CAD, GBP/JPY, USD/CHF, EUR/GBP, as well as AUD/JPY.
Nadex offers commodity binary options related to the price of crude oil, natural gas, gold, silver, copper, corn and soybeans.
Trading news events is also possible with event binary options. Buy or sell options based on whether the Federal Reserve will increase or decrease rates, or whether jobless claims and nonfarm payrolls will come in above or below consensus estimates. (For more on this topic, see Exotic Options: A Getaway From Ordinary Trading)
Pick Your Time Frame
A trader may choose from Nadex binary options (in the above asset classes) that expire hourly, daily or weekly.
Hourly options provide opportunity for day traders, even in quiet market conditions, to attain an established return if they are correct in choosing the direction of the market over that time frame.
Daily options expire at the end of the trading day, and are useful for day traders or those looking to hedge other stock, forex or commodity holdings against that day's movements.
Weekly options expire at the end of trading week, and are therefore traded by swing traders throughout the week, and also by day traders as the options' expiry approaches on Friday afternoon.
Event-based contracts expire after the official news release associated with the event, and therefore all types of traders take positions well in advance of -- and right up to – the expiry.
Advantages and Disadvantages
Unlike the actual stock or forex markets where price gaps or slippage can occur, the risk on binary options is capped. It's not possible to lose more than the cost of the trade.
Better-than-average returns are also possible in very quiet markets. If a stock index or forex pair is barely moving, it's hard to profit, but with a binary option the payout is known. If you buy a binary option at $20, it will either settle at $100 or $0, making you $80 on your $20 investment or losing you $20. This is a 4:1 reward to risk ratio, an opportunity which is unlikely to be found in the actual market underlying the binary option.
The flip side of this is that your gain is always capped. No matter how much the stock or forex pair moves in your favor, the most a binary option option can be worth is $100. Purchasing multiple options contracts is one way to potentially profit more from an expected price move.
Since binary options are worth a maximum of $100, that makes them accessible to traders even with limited trading capital, as traditional stock day trading limits do not apply. Trading can begin with a $100 deposit at Nadex.
Binary options are a derivative based on an underlying asset, which you do not own. Therefore, you're not entitled to voting rights or dividends that you'd be entitled to if you owned an actual stock.
The Bottom Line
Binary options are based on a 'yes' or 'no' proposition. Your profit and loss potential are determined by your buy or sell price, and whether the option expires worth $100 or $0. Risk and reward are both capped, and you can exit an options at any time before expiry to lock in a profit or reduce a loss. Binary options within the U.S are traded via the Nadex and CBOE exchanges. Foreign companies soliciting U.S. residents to trade their form of binary options are usually operating illegally. Binary options trading has a low barrier to entry, but just because something is simple doesn't mean it'll be easy to make money with. There is always someone else on the other side of the trade who thinks they're correct and you're wrong. Only trade with capital you can afford to lose, and trade a demo account to become completely comfortable with how binary options work before trading with real capital.