What is Binary Options Trading: Using a Simple Heads or Tails Style Financial Product
Key Questions Answered
Binary options are seemingly one of the most straightforward financial products. In binary options trading, you simply bet on whether a certain product will reach a specified price point by a specified time.
Despite this simplicity, binary options are hard to turn a profit from unless you are well-familiar with this product type.
What Is Binary Options Trading?
Binary options are financial products that let you bet on an asset’s price rising above or falling below a certain level at a certain time in the future. For example, you may bet on whether the price of crude oil rises above $75 by 12pm on December 13.
If you believe that oil does indeed increase above this price point at noon on December 13, you buy this binary option. However, if you think that oil will stay at or below $75 by that time, you sell this binary option.
If your binary option choice turns out to be correct, you get a fixed payout of $100. Otherwise, you earn nothing from this binary.
Binary Options Price
Binary options are priced between $0 and $100 each. A binary option product has buy and sell prices, with some spread between them. Depending on the binary offered, this spread could be very little, e.g., less than a dollar, or it could be as high as $10 or more.
For example, the binary option of $75 for oil by 12pm on December 13 might have a buy price of $60 and a sell price of $58. If you buy this binary, and your bet turns out to be correct, you earn $40 in profit, since you bought the options for $60 and were paid a fixed sum of $100.
If your bet is unsuccessful and oil stays below $75 at 12pm on December 13, you lose $60, the price you paid for the binary option.
Conversely, if you believe that the price of oil stays under $75 by that time and date, you may sell the binary option at the $58 sell price. If your bet turns out right, you will earn a profit of $42 ($100 payout minus the $58 sell price).
The buy and sell prices for a binary option are necessarily fixed. Any trader may offer to buy the option for less than the current buy price. Continuing with our example, you do not have to buy at $60. Instead, you may offer your price, e.g., $59, and wait for a trader willing to sell this option to you. Similarly, you may set a price above the current sell price for an option you are willing to sell.
Binary Options Fees
It should also be noted that the profits and losses you make with binary options normally exclude any fees charged by the brokerage and exchange. If you buy an option for $60 and get paid $100 for betting on the right price, the $40 profit you have just made will be further reduced due to the fees and charges. Most exchanges where binary options are traded charge $1 for buying and selling each option.
Furthermore, some brokers may charge a small percentage commission on the profits you make, while others levy fees only on withdrawals from the account when trading in binary options. Since the overall fees may be substantial, it is always worth carefully checking the fee structure of the brokerage and exchange you plan to use for binary options trading.
What Determines the Price of Binary Options?
As noted above, binary options are always priced between $0 and $100. The only determinant of a price for a binary option within this range is the estimated likelihood of the price moving above or staying under the specified level.
Binary options where the market estimates a higher likelihood of the event happening, e.g. the price of oil moving above $75, have buy and sell prices closer to $100. Conversely, if the market assigns a higher likelihood to the event not happening, i.e., the price of oil not rising above the $75 level specified in this option, then the binary’s buy and sell prices will be closer to $0.
If the likelihood of the event happening vs not happening is quite similar, the price of the binary options will be closer to the $50 mark, e.g., $55 buy and $52 sell price.
The spread between the buy and sell prices of a binary option is largely determined by the overall activity with regard to that option. If it is a popular product and many traders are buying and selling this binary option, the spread is likely to be smaller. The less popular and sparsely traded the option is, the larger its spread will be.
What Are the Advantages of Binary Options Trading?
Binary options provide a number of advantages to traders, such as:
- Fixed risk/capped potential loss. Unlike other forms of trading, the losses in binary trading are fixed. Regardless of the magnitude of change in the asset prices, your potential loss is limited by the price you have paid for the option.
- Ease of trading. Binary options are a straightforward product to understand, even for novice traders. There is only one out of just two possible outcomes. This is much simpler than many other financial products. However, despite their straightforward nature, binary options may not be an easy product to make consistent gains with.
- Variety of the available assets. Binary options are considered a derivative product, i.e., they represent other underlying assets. The range of the assets accessible through binary options includes stocks, commodities, cryptocurrency, foreign currencies, and others. Thus, binary options are a great way to access a wide variety of different asset classes.
- Higher potential returns. Binary options are a relatively risky financial product and as such, offer higher potential returns. Traders with a penchant for high risk/high reward products may find them appealing.
- Better returns in stagnant markets. When a particular market stagnates, i.e., does not move up or down in a significant way, it is hard to profit from trading in it. Binary options offer an opportunity to profit even in these kinds of stagnant markets. All you have to do is to bet on an asset crossing a particular price level. If your bet is successful, you get your $100 regardless of the magnitude of the price change.
- Low minimum capital requirements. You can start binary options trading with as little as $100, the typical minimum deposit required at the exchanges specializing in this product. This opens up opportunities for novice traders with even the tiniest starting capital.
What Are the Disadvantages of Binary Options Trading?
Despite the numerous advantages of binary options, they come with a number of non-trivial risks and drawbacks, namely:
- Capped returns. Along with the advantage of capped losses, binary options are limited by capped returns. Each binary option pays $100 regardless of the magnitude of the change in prices.
- Risky nature. Being a derivative product based on future price speculation, binary options are considered a high-risk financial product. Novice traders without experience with binary options may suffer significant losses when trading them.
- Presence of the “house edge”. The concept of the house edge is well-known to casino players and sports bettors. It denotes the guaranteed profit the casino or bookmaking agency will make regardless of the bets placed. The larger the house edge, the harder it is for casino players or sports bettors to turn a profit.
Binary options exchanges have a similar house edge built into their rates. In many cases, this house edge is well above the typical edges at casinos or sports betting agencies. It is not unusual for the exchange’s house edge to be as high as 15% to 20%. In comparison, the typical house edges of casinos and bookmakers are between 0.5% and 3%.
In real terms, this means that binary options trading is very tough to turn a consistent profit from. While some experienced and skilled binary options traders may be profitable, many others are not.
How to Trade Binary Options?
The key exchanges for binary options trading are Nadex (North American Derivatives Exchange) and CBOE (Chicago Board Options Exchange).
Additionally, Bitcoin and other crypto binary options may be traded at some cryptocurrency derivative exchanges that offer this product type.
It should be stressed that in recent years, many online binary options trading platforms with questionable credentials have mushroomed. Many of these platforms offer too-good-to-be-true options, such as significant cashback in the case of an unsuccessful bid on an option, to lure traders.
These providers are virtually unregulated, and many scams have been reported by ripped-off traders. Thus, you are advised to exercise caution and do your research when considering these platforms.
Binary options, despite their seeming simplicity, require a lot of experience with this product to be successful. Binary options trading is not something that a rookie trader should attempt.
When trading binary options, you would normally use the analysis methods that help you identify price chart events such as momentum as well as the emergence of a break in a trend. The common methods to identify such market events include RSI, MACD, SMA, and EMA.
Bitcoin Binary Options
Bitcoin binary options trading is now as widely-available as traditional binary option products. You may trade Bitcoin binary options on the majority of crypto derivative exchanges. Among the non-crypto exchanges, the availability of Bitcoin binary options may be limited.
The main non-crypto platforms where Bitcoin binary options are typically available are CME Group and CBOE. However, CBOE makes this product unavailable to traders from time to time.
Conclusion
Binary options may be a great product for traders who prefer simple choices and capped risks. However, despite its seemingly simple nature, binary options trading may be hard for less experienced traders.
The presence of the “house edge” in-built into the pricing and the generally risky nature of binary options make them a difficult product to turn a consistent profit from.
If binary options trading appeals to you, you may get your hands dirty with it on exchanges such as Nadex and CBOE, as well as on a number of crypto exchanges specializing in derivative products.