What are Binary Options?
Binary options are a simple financial product which allow investors to basically choose whether an asset will go up or down over a prescribed period. Returns are fixed and so is the risk, so this takes a lot of the ambiguity out of trading decisions. Also, once you buy an option you either receive a fixed payout or lose your investment when the option expires. This takes the guess work out of choosing when to exit a losing or profitable trade.
There are risks though, and some things you need to aware of before trading binary options. The simplicity of these products is alluring, but that can actually entice traders to begin trading binary options when they are not ready or educated enough to begin.
Binary Options Basics For Beginners
There are multiple forms of binary options, each with their own advantages and disadvantages. The most common form of binary option is the “vanilla” or basic binary option. Typically the current price of the asset will be shown on your trade screen and you will be asked if you think the asset will be higher or lower at a future time.
If you believe the price will be higher, you buy a “call” option, usually reflected by an up arrow. If you believe the price will be lower, you buy a “put” option, usually reflected by a down arrow. The “future time” is called the Expiry. In order to “win” the trade, the price must be where you predicted at the time of expiry. Typically once you place a trade you can’t exit until the expiry. If you are right in your prediction you receive a fixed payout, if you are wrong you lose the money you placed on the trade.
Figure 1. A typical binary option trade screen.
The current rate in the EUR/USD is 1.33093. The expiry is 13:15, and the current time is 13:01:26 as shown on the upper right. Therefore, if you buy a call or put you are attempting to predict whether the EUR/USD will be higher or lower (respectively) than 1.33093 in about 14 minutes from now.
If you want to trade a slightly longer time frame, such as predicting where the EUR/USD will be 1 hour from now, you can choose a different expiry time using the drop down menu entitled “Expiry” toward the upper middle of figure 1. You can also choose a different asset via the drop down menu next to the Expiry.
You choose how much money you wish to place on a trade. You would enter this dollar amount in the “Amount” box and then click “BUY after selecting Call or Put. Your potential return is shown up front–in this case 180%. If you place a $100 trade and are correct, you will receive $180; you have made $80 or 80%. If your prediction is wrong, you lose $100 or %100.
The number and diversity of assets you can trade with binary options varies from broker to broker. Most brokers provide binary options on popular assets such as major forex pairs including the EUR/USD, USD/JPY and GBP/USD, as well as major stock indices such as the S&P 500 or Dow Jones Industrial. Commodities including gold, silver, oil are also generally offered.
Individual stocks are also tradable through many binary options brokers now. Not all stocks are tradable though, but generally you can choose from about 10 to 50 popular stocks, such as Google and Apple.
You can see what assets your preferred broker offers by going to the trade screen on their site and viewing the drop down menu of assets. If you want more information on the underlying asset, the broker should have an “Asset Index” or “Asset Specifications” page which outlines which assets you can trade, the times of day you can trade the asset, and any other pertinent information you should know.
Figure 2 shows a website screen shot from binary options broker. It is their Asset Index. You can click on the multiple tabs to see information on the assets offered in the Indices, Commodities, Currencies and Stock categories. The stock category has been selected so the screenshot shows some of the stocks they offer binary options in with a bit of background on the stock.
Figure 2. Asset Index
Types of Binary Options
There is the basic binary option which was discussed earlier; a trade based on whether you believe the price at expiry will be higher or lower than the current price.
There are also other types of options though, two in particular which seem quite popular.
Touch binary options are not based on where the asset price is at expiry, but whether an asset price touches a specific level at any time before expiry. With some brokers only one price is given and then you must choose between “Touch” or “No Touch” depending whether you think the asset price will touch the price in question before expiry or not
Other brokers offer two prices, and you can choose whether you think the price will touch the upper or lower threshold. Figure 3 shows an example of this.
Figure 3. Touch Binary Option
Here we are looking at the Dow Jones. The expiry is at 13:45 and the current time is 13:39:46. The countdown clock shows there is only 14 seconds left to place trades, as most brokers don’t allow trades within several minutes of the expiry time.
This option gives you the choice of picking a “touch up” or a “touch down.” If you pick Touch Up the asset needs to touch 15438.246 in order for you to win. The return if you win is 210%–if you bet $100 you will receive $210. If the price doesn’t touch that level you will lose your $100.
If you pick Touch Down the asset needs to touch 15424.404 in order for you to win. The return if you win is 210%.
To win on the Touch Up you need to Dow to rise about 7 points within the next 5 minutes . To win with the Touch Down you need the Dow to fall about 7 points within the next 5 minutes.
With Range Binary Options you need to pick whether an asset will finish In or Out of a defined price range. At expiry the price of the asset must be inside the range to have a winning trade if you selected In.
If you selected Out, the asset must be outside the prescribed range at expiry in order for you to win.
If you win your payout will typically be between 60% and 80%–if you bet $10 you will receive $16 to $18. If you lose, you will lose your $10.
If you look through several different brokers’ trade screens you will immediately see that payouts or returns vary between brokers. Some payout are as high as 80% while others are more toward 60 or 70%. The “fine print” can sometimes shed some light on these varying payout levels.
Some brokers offer a small rebate on losing trades, such as 5% or 10%. So if you place a $100 trade and lose, you don’t lose your entire investment, you get $5 to $10 back in this case. No all brokers do this, but some do, and may be why payouts are a bit lower. With this losing-trade-rebate your risk is a bit smaller, but likely your payout will be too.
Also, binary options are largely unregulated, which means most binary options brokers can create all sorts of products which will vary from broker to broker. This means comparing one broker to another isn’t exactly like comparing oranges to oranges. Even basic binary options can vary between brokers.
Some brokers also provide additional tools you can use to help with your trades. “Sentiment” indicators are a popular one. When you pull up an asset in the trade screen you may see a green and red indicator named “Call/Put” or “Bulls/Bears” or “Traders Choice.” What these indicators tell you is what percentage of traders (currently trading that option with that broker) have bought calls and puts. The green percentage is usually Calls and the red percentage reflects Puts. Figure 4 shows Cedar Finance’s sentiment indicator for the EUR/GBP called Trader’s Choice.
Figure 4. Trader’s Choice Sentiment Index
This indicator shows that 45% of trader have bought Calls, or think the EUR/GBP will rise. 55% believe the price will fall and have bought Puts.
Binary options are quite simple once you have played around with a demo account for a few minutes. You can type in the amount you want to trade and the trade screen will typically show you much you will win or lose depending on whether you are correct or not.
This simplicity can be misleading though. You are still trading a financial asset, and as such there are financial risks. While the risk is limited on each trade to the amount you place on the trade, a string of losses can result in a significant loss of capital or the account being cleaned out. To help preserve capital one of the most important things to learn is how to determine your position size on each trade. Before you begin trading you also want to write down a trading plan which details how, why and when you will trade.
With binary options you can nearly double your money quite quickly, with returns sometimes up to 80% or more. But in most cases your risk is always greater as typically you will lose 100% of the dollar amount placed on the trade if you are wrong. Therefore, you must be right more often that you wrong; typically you will need to be right about 55% to 60% of the time to breakeven.
Take figure 4 for example. The payout is 80% on your capital (and you receive your capital back, so they say 180%)
Figure 5. AUD/USD Binary Options Trade
A call has been selected, and $100 wagered. If the trade ends up profitable, I will receive an additional $80 but if there is a loss the $100 is gone. If you win 6 trades betting $100 you will make 6x$80=$480 minus the $400 you lost on the 4 losing trades (4x$100), so you net $80. If you only win 5 times (a 50% win rate), you make 5x$80=$400 on your winning trades, but lose $500 on your losing trades (5x$100) giving you net loss of $100.
Therefore, before you trade binary options take time to prepare strategies which have a high winning percentage. Then test those strategies on a demo account before using real money. Only when you are making consistent returns on the demo account, over a several month period, should you begin trading real money.
Binary options have advantages and disadvantages. Mainly they are simply to use and understand and offer high payouts and fixed risk. The downside is that generally you will need to have a high winning percentage–over 50%– in order to come out ahead. Take time and prepare some strategies before jumping into trading binary options. Demo accounts are free to try and use so take advantage of it, honing your skill and establishing a winning track record before risking real capital. Also, before choosing a broker be sure to compare what they are offering and any advantages or disadvantages they have relative to one another. Do research on the broker before providing your personal or financial details.