What is Nadex
Nadex stands for the North American Derivatives Exchange, a regulated Chicago-based exchange where retail traders can buy and sell binary options directly on the exchange without a broker. Nadex, which is subject to oversight by the Commodity Futures Trading Commission, offers binary option contracts and spreads in equity indexes, commodities, forex, and economic events.
Breaking Down Nadex
Nadex is the first and largest regulated U.S. exchange for binary options, which are simple yes/no trades with a downside risk that is known at the outset of the trade. Unlike over the counter derivatives, there is no counter-party credit risk. Nadex clears and guarantees all trades done on the exchange. Pricing is transparent and all positions are fully collateralized at all times. Member funds are held in segregated U.S. bank accounts.
Nadex Binary Options
Binary options on Nadex settle at $0 or $100, and will trade at some level between $0 and $100 prior to expiry. Traders can choose to trade options with varying expiries, from very short-term to longer-term. They can also trade a wide array of financial instruments.
For example, assume a trader believes that gold, which is currently trading at 1288, will be above 1290 by noon today. The >1290 (noon) option is currently trading at $30. They would buy a 1290 binary option for $30. Someone else needs to be on the other side of the transaction, and they sell at $30 expecting the price to stay below 1290.
If gold is above 1290 at expiry, then the option settles at $100. If gold is below 1290 at expiry, the option settles at $0. How the option settles determines the profit or loss for each trader.
If the option settles at $100 (gold above 1290 at expiry), then the buyer makes $70. They paid $30 and the option is now worth $100. The seller loses $70. They sold a $30 option which is now worth $100. Notice how the gain of one trader is equal to the loss of the other.
Now, compare the risk. The buyer of the option bought at $30. The least the option can be worth is $0, so they are risking $30 to make $70. The seller has the inverse risk/reward. They are selling at $30, but it could potentially go up to $100 (risk), or down to $0 (reward). Therefore, their maximum gain is $30 while their risk is $70.
The price of the option can be thought of as a probability. An option that can be bought for $10, $20, or $40 has more upside than risk, yet there is also a lower likelihood that the option will settle at $100. If an option is trading at $10, it has a $90 upside and only $10 of risk, but traders are betting there is a low probability that the option will settle at $100.
Multiple contracts can be purchased to increase position size and thus risk and reward.