What if you could trade a stock and know exactly what you will win or lose? Binary options are a lure for new traders because they are simple to use and your potential gain or loss is known in advance.
Do you think the price of gold will be above or below X amount in 10 minutes – Yes or No?
If your bet is correct, you get a fixed pay out. If you are wrong, you lose the cost of the options contract. The outcomes and your risk are clearly defined.
If you bet on the horses or football games, then you are very familiar with this win or lose proposition called gambling. Binary options have been compared to bets on a roulette wheel – Do you expect the ball to land on an even or odd number? – and even Russian roulette.
If you are looking to make easy money, you are not likely to find it in binary options trading. Whether or not binary options are a form of gambling or investing depends on the learning, skill and experience you dedicate to trading them. If you toss a coin – heads the price will rise, tails the price will fall – your chances of winning are 50/50. After trading fees, you will inevitably lose money. This is gambling. Alternatively, like any good trader, you can use fundamental and technical market analysis to decide whether to buy or sell a binary option.[toc]
What Are Binary Options?
Binary options are an all-or-nothing bet on the future price of an underlying asset. The trader receives a fixed payout if the price of an underlying asset (e.g., currency pair, stock) hits a preset level at a preset expiry date. The expiry date may range from a minute to a month, but is generally intraday (minutes to a few hours). Here are two examples of fixed-return high-low binary options:
Market price – In a simple high-low binary option trade, the trader chooses whether the expiry price will be higher or lower than the market price (the strike price). The trader buys a binary option betting the gold price will rise above the current market price of $1,300 in the next five minutes.
Set price level –The trader buys a binary option betting the price of gold will reach 1,310 in two hours. If in two hours the price of gold is above the strike price, the trader receives a payout. If it is below the strike price, the trader loses the cost of the option.
Why Should I Trade Binary Options?
Binary options allow you to easily place money behind your opinion on a market? Do you expect the price of gold to rise above $1,300? Will Netflix stock rise or fall after today’s earnings announcement? Will the unemployment rate report show an increase or decrease?
Let’s take the unemployment report as an example. A falling unemployment number is a bullish signal for the US market that can strengthen the USD against the EUR. If US unemployment falls, traders short the EUR/USD. If unemployment rises, traders typically go long the EUR/USD.
There are many barriers to buying an option on the bet that the EUR/USD will rise based on a higher US unemployment rate.
- Your broker may require a higher account minimum to trade options
- The size of potential losses if the EUR/USD price falls is unknown
- The price could rise but not enough to cover the bid-ask spread after fees
- The orders of large traders with faster executions speeds will be filled first, which could result in price slippage
- The use of leverage will magnify any losses
- In the event of losses, you could receive margin calls
Th binary option, in comparison, has two possible outcomes:
🔺The price rises above the strike price – The unemployment report is negative, the USD price falls and the EUR/USD price rises. You get a payout.
🔻The price falls below the strike price – If the currency pair falls below the strike price before the expiry time, you lose the cost of the option.
How the payout is calculated can differ among binary options providers. See the binary options broker and exchange examples below for two popular payout models.
- Simple binary choice – ‘Yes’ or ‘No’
- Risk, potential loss, is predetermined by amount of trade
- Potential reward is predetermined
- Cannot lose more than what you have bet
- High risk of loss of capital
- All-or-nothing bet
- A one pip difference from the strike price and the trade is out-of-the-money and pays out 0
- Not legal or available to retail traders in some jurisdictions
How to Start Trading Binary Options at a Broker:
Binary options are called naked options for good reason. Because the writers of these options do not own the underlying asset, they face high price risk exposure. Traders, however, do not have to be completely naked. By using risk management tools, you can gain more control over your potential gains and losses when trading binary options.
The account minimum varies among brokers. In the US, traders can trade binary options on the Nadex exchange with a $250 account balance. In Europe, traders must be designated as professional traders to trade binary options with a broker. This involves meeting two of three requirements: an investment account balance of more than EUR 500,000, an average of 10 transactions per quarter over four quarters, one year professional experience in the financial sector.
Your earnings potential as a binary options trader depends on your experience, skills and expertise. Prudent traders control their potential gains and losses by using the 1 percent risk rule: Never trade more than 1 percent of the value of your portfolio on one trade. If you choose to borrow on margin to increase your buying power, your potential gains and losses will be magnified by the leverage amount.
Unlike many derivatives such as CFDs, futures and options, binary options are generally not traded using borrowed money, also known as margin borrowing. A leverage of 20:1, for example, would involve borrowing 20 times the amount of cash and securities in your investment account. An account with a value of 5 euros would be able to trade using 100 euros.
Binary options brokers are adding traditional risk management tools such as stop-loss and limit orders, though not all will provide these order types. Stop orders are a popular way of limiting downside risk while trading. The two most popular are:
Stop-loss order – Stops out the trade when the price falls to the predetermined stop price.
Trailing stop – Follows the price within a range (e.g. 10 pips). The trade is closed if the stock price passes through the trailing stop level, thereby limiting downside risk.
Because binary options have a high risk of loss, they are banned in many countries. In Europe, professional traders may trade them but they are off limits to retail traders. Anyone anywhere in the world can download a binary options broker app and start trading. If the broker is unregulated and goes out of business, your losses will not be covered by investment account insurance. Offshore brokers are prohibited from marketing to US residents. Also be aware that many binary option dealers have been shut down owing to fraudulent activities.
Under the new ESMA rules enacted in July 2018, retail traders can no longer trade binary or digital options. Retail traders can trade CFDs with up to x30 leverage. Traders with Professional trader designation can trade binary and digital options with up to x500 leverage, and their accounts benefit from negative balance protection. Refer to ESMA or your broker’s qualifications to upgrade to a professional account.
Both binary and digital options are priced based on whether the settlement price is higher or lower than the strike price. The return on a binary option is a fixed percent of the amount invested and based on the spread, volatility, time of day, cost and other factors. The return on a digital option varies and is based on how far the price moves from the strike price. On a buy order, for example, as the price moves higher than the strike price, your potential profit increases. As the price moves lower than the strike price, the potential loss increases.