Binary options, sometimes called digital options, are a type of option in which the trader takes a yes or no position on the price of a stock or other asset, such as an ETF or currency, and the payoff is all or nothing. Based on these characteristics, binary options are easier to understand and trade than traditional options.
Step
Method 1 of 3: Understanding Important Terms
Step 1. Learn options trading
An "option" in the stock market refers to a contract that gives you the right, but not the obligation, to buy or sell a security at a certain price on or before a certain date in the future. If you believe the market will go up, you can buy a "Call", which gives you the right to buy a security at a certain price through a future date. Doing so means you think the price of the stock will go up. If you believe the market is falling, you can buy a "Put", which gives you the right to sell the security at a certain price until a future date. This means that you are betting that prices will be lower in the future than they are currently trading.
Step 2. Learn binary options
Also called fixed return options, they have a predetermined expiration date and time and potential return. Binary options can only be exercised on the expiration date. If at expiration, the option is above a certain price, the buyer or seller of the option receives a predetermined amount of money. Similarly, if the option is below a certain price, the buyer or seller receives nothing. This requires an assessment of the risk of a known increase (profit) or decrease (loss). Unlike traditional options, binary options provide full payout no matter how far the asset price is above or below the "strike" (or target) price.
- For example, you bet that Company X's stock price will be above $15 on July 10 at 3pm, and you buy a binary call option for $50 with a predetermined payout of $100. If at 3 pm on July 10, Company X's stock price was $16, you would be paid $100 at a profit of $50. If the stock price is $14, you will lose your $50.
- Some binary options will pay out if the stock price is met during a specified period. So, if the stock is $16 at 1 pm on July 10 but then drops to $14 at 3 pm, you still earn $100.
Step 3. Learn how contract prices are determined
The bid price of a binary options contract is approximately equal to the market's perception of the probability of the event occurring. Binary options prices are presented as ask/bid prices showing the ask (sell) price first then the bid (buy) price, for example, 3/96, which is the ask price of $3 and the bid price of $96.
- For example, if a binary options contract with a settlement (payout) price of $100 has an ask price of $96, this means that most of the market thinks that the underlying commodity meets the terms of the option and achieves a full payout of $100, either rising above or falls below a certain market price.
- This is why this option, in this case, is so expensive; much lower risk.
Step 4. Learn the terms "in-the-money" and "out-of-the-money"
For call options, in-the money occurs when the strike price of the option is below the market price of the stock or other asset. If in a put option, in-the-money occurs when the strike price is above the market price of the stock or other asset. Out-of-the-money is the opposite when the strike price is above the market price for a call option, and below the market price for a put option.
Step 5. Understand one-touch binary options
This is a type of option that is becoming increasingly popular among traders in the commodity and foreign exchange markets. This type of option is useful for traders who believe that the price of the underlying stock will exceed a certain level in the future but are unsure of the sustainability of higher prices. This option is also available for weekend purchases when the market is closed and may offer higher payouts than other binary options.
Method 2 of 3: Binary Options Trading
Step 1. Know the two possible outcomes
A binary options trader must be able to anticipate the price movements of stocks or other assets such as commodity futures contracts or currency exchanges. In most platforms, the two options are called "put" and "call". A put is a prediction of a decrease in price, while a call is a prediction of a price increase.
Unlike traditional options, you don't have to anticipate the magnitude of the price movement. Instead, you just have to be able to correctly predict whether the price of the selected asset will be higher or lower than the "strike" (or target) price at a certain time in the future
Step 2. Determine your position
Evaluate current market conditions around the stock or other asset of your choice and determine whether the price is likely to rise or fall. If your insight is correct on the expiration date, your payment is the settlement value as stated in your original contract. The rate of return on each winning trade is set by the broker and is known in advance.
For example, let's say an investor following foreign currency movements feels that the USD (US dollar) is starting to strengthen against the JPY (Japanese yen) and wants to hedge the risk and try to prevent his Japanese investment from falling in value. He can do this by buying 10,000 binary contracts stating that "USD/JPY will be above 119.50" by 4pm ET tomorrow. If the analysis is correct and the USD strengthens against the Yen, rising above 119.50, then those 10,000 binary contracts will expire in-the-money, resulting in a total payout of $1,000,000. If the investor pays $75 per contract, he will make $25 per contract, which is a total profit of $250,000, a return on investment of 33%. However, if the yen does not end above 119.50, then those 10,000 binary contracts will expire out-of-the-money. In this case, the trader will lose his initial investment in the binary contract, but will be compensated for the gain in the value of his investment in the Japanese yen
Step 3. Learn the advantages of trading binary options over traditional options
Binary options are generally simpler to trade because they only require a prediction of the direction of the stock price movement. Traditional options require prediction of the direction as well as the magnitude of the price movement. No actual shares were bought or sold. So, selling shares and stop-losses are not part of the process.
- A stop-loss is an order you will place a stockbroker to buy or sell once the stock reaches a certain price.
- Binary options always have a controlled risk-reward ratio, meaning that the risk and reward are determined at the time the contract is acquired. Traditional options have no fixed risk and reward limits, and therefore the advantages and disadvantages are unlimited.
- Binary options can involve the trading and hedging strategies used in traditional options trading. You should always do a market analysis before making any trades. There are many variables to consider when trying to decide whether the price of a stock or other asset will go up or down over a certain period of time. Without analysis, the risk of losing money will increase substantially.
- Unlike traditional options, the payout amount is not proportional to the final option amount. As long as the binary option finishes ahead by even one number, the winner receives the entire set payout amount.
- Binary options contracts can last almost any timeframe, from minutes to months. Some brokers provide contract times as short as thirty seconds. Other brokers can last a year. This provides great flexibility and almost unlimited money-making (and losing-money) opportunities. Traders need to know exactly what they are doing.
Method 3 of 3: Understanding Costs and Where to Buy
Step 1. Learn where binary options are traded
Binary options are very popular in Europe and are widely traded on major European exchanges, such as EUREX. In the United States there are several places to trade binary options:
- The Chicago Board of Trade (CBOT) offers binary options trading at the Target Fed Funds Rate. To trade this contract, the trader must be a member of the exchange. Other investors must trade through members. The value of each contract is $1,000.
- Nadex is a binary options exchange regulated by the United States. Nadex offers various expiry times (hourly, daily, weekly) opportunities that allow traders to take positions based on market developments. The options are vast with more than 2,400 binary options contracts every day. These contracts range from popular currency pairs (such as GBP/USD) to major commodities such as gold and oil. Member funds are held in separate US bank accounts, in accordance with Commodity Futures Trading Commission (CFTC) regulations providing an additional layer of security.
Step 2. Check the transaction fees and potential benefits
Binary options brokers may not charge any fees per trade, nor may they take any commissions. You should also understand the percentage of time you predict correctly in order to profit from the binary options you are considering.
- For example, if you buy options for $40 each and each has a settlement value of $100 if you are correct, you must be correct 2 out of 5 times to break even, and more than that to make a profit (cost: 5*$40 = $200, return: 2*$100 = $200).
- Survey several brokers before making a choice. Each broker will provide its own trading platform, contract terms, assets, rate of return and educational resources. Each of these elements can affect the overall earnings potential.
Step 3. Know the transaction fees beforehand
It is very rare and difficult to outperform the market continuously. This means that options traders usually have to engage in many transactions in order to eventually land a profitable position. As a result, a trader faces the possibility of high transaction fees and lower profits.
Step 4. Know the trading terms for each transaction
How different are the terms (for example, "strike price") on one side of the trade (above the strike price) compared to the other side (below the strike price)? If they differ significantly, buyers will be forced to enter into unusual positions because they have to estimate the magnitude and direction of price movements.
Tips
- Know how to interpret binary options prices. The price at which a binary option is traded is an indicator of the likelihood of a contract being terminated in-the-money or out-of-the-money.
- Understand the relationship between risk and reward. The two go hand in hand in binary options trading. The less likely a particular outcome is, the greater the reward associated with taking it. A savvy investor understands and considers each contract on these two matrices before taking a position in a contract.
- Know when to get out of position. An intuitive trader will act immediately when he senses that his binary contract will expire out-of-the-money when it expires. Example: You have a $75.00 silver contract that you think will not expire in-the-money. Instead of holding them until the expiration date, selling them for $30.00 and neutralizing your open shares will help you manage losses (at a loss of $45 instead of $75 after confirmed expiration in an out-of-the-money condition).
- Know the underlying stock or other asset. Binary options derive their financial value from the underlying asset. Before investing in binary options, make sure you understand the underlying asset. Get to know the relevant financial markets and where the assets are traded. Example: Silver Futures are listed on NYMEX/COMEX.
Warning
- If the explanation above makes binary options trading sound like gambling, that's because it is. Binary options are very similar to betting in a casino. It is quite possible to make money in a casino or in options trading, but these two games require a great deal of knowledge, skill, experience and courage. Make sure you do enough options trading to make money consistently in both traditional and binary options trading.
- Resist the temptation to accept bonuses from brokers. Bonuses are basically free money given to binary options traders on certain online trading platforms. However, this bonus will magnify your losses just as quickly as it increases your winnings, potentially causing you to spend your initial investment much more quickly on a small number of bad trades. In addition, bonuses may come with conditions requiring you to invest several times before withdrawing your money, or other strict rules.
