Binary Options - A Simple All or Nothing Position
As the name suggests, a Binary Option is a type of option where the payoff is all or nothing. Because of this characteristic, Binary Options can be easier to understand and trade than traditional options.
Binary Options are cash-settled as European-style options, i.e. they can only be exercised on the expiration date. If, at expiration, the options settle in-the-money, the buyer or seller of the options receives a pre-specified dollar amount. Similarly, if the options settle out-of-the-money, the buyer or seller of the options receives nothing. This provides a known upside (gain) or downside (loss) risk assessment, and unlike traditional options, Binary Options provide full payout due to a single pip movement.
Things to know about trading Binary Options Binary Options Have Two Outcomes
A trader of Binary Options needs to anticipate the expected direction of the price movement of the underlying asset. Unlike traditional options, knowing the direction of the price movement, as well as magnitude of the movement, is not required. If the investor has an opinion about an underlying asset and wants to places a trade, s/he can trade Binary Options.
There Are Two Ways to Take a Position - Buy or Sell.
Buy, if you believe the market price will rise or the economic event will occur. Sell, if you think the
opposite. If your insight is correct, on the expiration date, your payoff is the settlement value of your
contract.
Understanding Probability and Opportunity The price of a Binary Option contract is equal to the probability of the event happening. For example, if
the contract value has a value of $100 and the last trade of the contract was at $96.00, it is an indicator
that 96% of the market believes that the event is going to happen and the contract will end up
in-the-money.
Advantages of trading Binary Options over Traditional Options1. Binary Options are generally simpler to trade because they require only a sense of direction of the
price movement of the underlying asset, whereas traditional options require a sense of direction as well as
the magnitude of the price movement.
2. Binary Options have controlled risk to reward ratio, meaning the risk and reward are pre-determined
at the time the contract is acquired. Traditional options have no defined boundaries of risk and reward
and therefore the gains and losses can be limitless.
3. Binary Options provide nearly all the trading and hedging strategies that are possible while trading
traditional options. Binary Options maintain a level of trading sophistication and functionality.
4. Unlike a traditional option, the payout amount is not proportional to the amount by which the option
ends up in-the-money. As long as a Binary Option settles in-the-money by even one tick (regardless of
how much in-the-money it is), the winner receives the entire fixed payoff amount.
5. Binary Options offer contracts with short-term durations. In some markets, Binary Options contracts close multiple times throughout the trading day, while others may last as long as a quarter. This provides the trader with several investment opportunities and flexibility as markets change over time.
Where are Binary Options traded? Binary Options have been enormously popular in Europe and are extensively traded in major European exchanges, like EUREX.
In the United States, there are a few places where Binary Options can be traded. The Chicago Board of Trade (CBOT) offers Binary Options trading on the Target Fed Funds Rate. To trade these contracts, traders must be members of the exchange or investors are required to trade through such members to execute a trade - the value of each contract is $1000.
The other exchange that offers trading on Binary Options is the HedgeStreet Exchange. Similar to the CBOT and NYMEX, HedgeStreet is a government regulated, financial trading exchange. Accounts on HedgeStreet can be opened and funded online for $100. HedgeStreet is a non-intermediated exchange, i.e., you do not need a broker to trade Binary Options on HedgeStreet.
Who trades Binaries? Binary Options are traded by the following investors:
1. Tech savvy speculators who are willing to potentially make a profit in the market.
2. An investor following financial movements in the market, wishing to potentially earn a profit by taking
a position on the direction of a market price.
3. Investors who wish to hedge their risk on investments like crude oil, gold, silver, earnings per
share, currencies, and even real estate prices.
4. A bank or an institution wishing to hedge its interest rate or currency risk.
Tips to Trade Binary Options 1. Know the underlying asset - Binary Options derive their financial value from underlying assets.Before investing in a Binary Options, make sure you understand the underlying asset, are familiar with the relevant financial markets and where the asset is traded. Example: Silver Futures are listed on NYMEX/COMEX.
2. Know how to interpret a Binary Option price - The price at which a Binary Option is trading is an indicator of the chances of the contract ending in-the-money or out-of-the-money.
3. Know when to get out of a position - An intuitive trader acts promptly when he feels that his binary contract is going to end out-of-the-money at expiration. Example: You have a $75.00 Silver
contract that you feel is not going to expire in-of-the-money. Instead of holding it until expiry, selling it at $30.00 and neutralizing your open interest will help you manage the loss (i.e. $45.00 instead of
$75.00).
4. Understand the relationship between risk and reward - Risk and reward go hand-in-hand in binary option trading. The more the risk or unlikelihood of a particular outcome occurring, the greater the reward associated with it. An intelligent investor understands and weighs each contract on these two matrices before taking a position in a contract.
As an example, an investor who follows foreign currency movements senses that the USD is gaining ground against the YEN and wants to hedge his risk and try to protect his Japanese investment from dropping in value. He may do this by buying 10,000 binary contracts on HedgeStreet, which are “USD/YEN rate will be above 119.50” by 4:00 PM ET tomorrow. If his analysis is correct and the USD gains ground over the Yen, rising above 119.50, the 10,000 binary contracts will expire in-the-money, yielding a total payout of $1,000,000. If he paid $75 per contract, he will make $25 per contract, which is a $250,000 total profit - a 33% rate of return on his investment. However, if the Yen did not end above 119.50, the 10,000 binary contracts will expire out-of-the-money. In this case, the trader would loose his initial investment on the binaries, but would be compensated by the gain in value in his Japanese investments.
Examples of Hedging Using Binaries 1. Foreign currency traders or investors, who want to hedge their risk against adverse currency
movements.
2. Futures traders and dealers of precious metals like gold and silver, who want to hedge their risk against
weakening prices.
3. Gas station owners could hedge against crude oil price increases, which would represent increased
product costs to them.
4. Shareholders who want to hedge their equity risk against poor company performance that does not
meet analyst expectations or a potential merger deal that might dilute their equity.
5. Home owners who want to hedge their risk against weakening real estate prices.
6. Bond holders who want to hedge their risk against falling fed fund and inter-bank interest rates.
