Understanding Binary Options

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Updated on Monday, January 27, 2020

Binary options are a simplified form of options trading. Options trading can be a little difficult to understand, but essentially when you trade options, you are buying or selling contracts that give you the right, or the obligation, to make certain asset trades in the future. Binary options remove much of this complexity, allowing you to bet on whether the value of an asset will be higher or lower than a target price by a given deadline. Simple, right? Let’s take a closer look at how binary options work and whether they make sense for your trading strategy.

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What are binary options?

Binary options — like all options — are a financial instrument based on the value of an underlying asset. This underlying asset can be a stock, a bond, a currency exchange rate or the price of gold. When you buy or sell binary options, you’re making a bet about the future price of the underlying asset.

Let’s say the price of gold right now is $1,450 an ounce, and you think it will be higher than $1,500 by the end of the week. You could buy a binary option with a strike price of $1,500 and a deadline of Friday at 5:00 p.m. If the price ends up higher than $1,500 on Friday at 5:00 p.m., you would make money. If the price ends up at $1,500 or lower, you lose money.

How are binary options priced?

Binary options are priced between $0 and $100. Their value is based on how likely the underlying asset will be above the strike price by the option deadline. If the actual value of the asset is above the strike price at the deadline, then the option is worth $100. If it’s below the price, then the option is worth $0.

Before the deadline, the value of the option will fluctuate between $0 and $100, depending on how likely the final result looks. If it looks very likely that the final price will be above the strike price, then the option price will be closer to $100. If it looks unlikely, the price will fall closer to zero. If you own a binary option and want to get out before the expiration date, you can sell the contract to another investor at the current market price.

How do you buy and sell binary options?

When it comes to binary trading, you can be either a buyer or a seller. Let’s go back to the example of gold going up to a value of $1,500. Imagine that the option currently trades at $45 — that means you’d pay $45 to bet that the price will end up higher than $1,500 by the deadline. If the price ends up higher, you’ll receive $100, giving you a profit of $55 (100 – 45 = 55.) If the price ends up at or below $1,500, your option value falls to $0, meaning that you’d lose your $45 investment.

On the other hand, if you think the price of gold will not be above $1,500, you could take the opposite position by selling the $45 option to another investor. This person would give you the money upfront, and if the price ends up below $1,500, you keep the $45 profit. If the price ends up above $1,500, you need to pay the option buyer $100, so your loss is $55.

Where can you trade binary options?

Since binary options are a newer, more specialized type of investment, you won’t find them with just any online stock broker. One way to make these investments is through the North American Derivatives Exchange (Nadex). This exchange is supervised by the Commodity Futures Trading Commission, a government regulatory agency.

There are other online websites that allow binary option trading, such as Binary.com and IQ Option. But Braden Perry, a former enforcement attorney at the Commodity Futures Trading Commission (CFTC), warns you have to be careful.

“Many internet-based platforms have surged into the market, and with that surge, the opportunity for fraudulent promotional schemes, overstatement of returns, and the failure to pay out for the wins have increased,” said Perry. “Furthermore, some actors are using manipulative software to rig the system, so winning bids end up losing.”

As he recommends, before opening an account with a website, you should check their registration and disciplinary history through BrokerCheck or the Background Affiliation Status Information Center, two databases run by regulatory agencies. You could also perform web searches to determine if your potential broker has been accused of wrongdoing.

What are the fees for trading binary options?

The fees for trading binary options depend on the broker or trading platform. They may charge a flat transaction cost, like $1 for each contract that you buy or sell. They might also charge a fee when they pay out the $100 earnings at a contract’s expiration deadline, known as a settlement fee. Once again this could be $1 per contract, charged to the investor who made the correct bet on the option.

Another way brokers can make money is by using a bid-ask spread, which means the price to buy an option is higher than the price to sell an option. For example, it costs $45 to buy but you would only receive $43 by selling. The $2 difference goes to the broker or the trading platform.

Finally, the broker/platform could charge additional miscellaneous fees for other actions, such as setting up your account or processing withdrawals.

Advantages of binary options

  • Simple to understand: Binary options are pretty straightforward compared to other options trading strategies — either your price prediction comes true and you make money, or it doesn’t and you lose money.
  • Fixed risk: Going into each trade, you can calculate exactly what your loss would be in the event that your prediction was wrong. With some other trading strategies, like short selling a stock, your possible loss is potentially unlimited; with binary options, it’s a fixed risk.
  • Higher potential returns: Investing is generally a tradeoff between risk and return, where higher risk investments tend to have a higher potential return. Since binary options can be relatively risky, they are also potentially lucrative. Due to the higher risk the typical returns on investments are much higher than foreign exchange trading — typically 60% to 90%, compared to 10% for forex.

Downsides of binary options

  • High risk: With the “all-or-nothing” payout system, you can lose money very quickly when trading binary options if your predictions turn out badly. This simplicity may be a downside for new investors, who could lose a lot of money through inexperience.
  • Bad market actors: You need to be careful about which trading platform you use. Binary options are a relatively new investment and still not regulated as closely as more established markets, so the opportunity for fraud can be higher.
  • Broker limitations: There could be limits on how much you can invest per trade. Only some brokers allow big investments, restricting them to clients with large balances. If you want to make larger investments, you may need to sign up with multiple platforms as you could go over the maximum limit on just one.

Who should trade binary options?

Binary options are a better fit for investors with a high-risk tolerance, those more willing to lose money in the short-term in exchange for making a larger profit in the future. If you’re scared about the idea of short-term losses, binary options are likely not a good fit.

In addition, you need to be willing to put in lots of research for your binary option trading decisions. You are competing against other investors, including Wall Street professionals, who are only accepting your buy/sell moves because they bet the opposite will happen and they’ll make money off you. It’s a tough market and takes hard work to make a profit.

Even if binary options sound like a good fit for your personality, Nicholas Hofer, a CFP® and President of Boston Family Advisors, still believes you should think twice before getting started: “I wouldn’t recommend this strategy for traditional investors as it’s more like gambling.”

He thinks binary options are a misuse of what options should be used for, as a hedge against risk and losses. “Unfortunately,” he noted, “‘hedging’ is now often viewed as a way to generate alpha [above market returns] rather than a way to reduce risk.”

Learn more about binary options

If you’d like more help to learn about binary options, there are online courses and bootcamps that can give you trading strategies and tips. You could also hire a financial advisor to help set up your options trading account and give you recommendations for trades.

The complicated part is not understanding how binary options work, but rather how to make good predictions. That means studying up on market trends, closely following financial news and learning everything you can about potential trades so you can make better predictions than the average investor.

If you do decide to move forward with trading binary options, make sure to do so responsibly — only invest money you can afford to lose. With research and some luck, you can make money quickly through binary options trading. But if you aren’t careful, you can lose it just as fast.

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