Binary options trading sounds too legit to be anything but above board. After all, this involves publicly traded stocks and commodities. Lately, however, it has been criticized as nothing more than gambling, pure and simple, yet the buzz around it is getting louder and the promise of easy money is attracting the attention of people from all walks of life. What is it, really, and is it something the ordinary weekend investor like you and me should even care about?
Binary is an apt adjective for this type of option. In programming parlance binary used to describe either of two states. 1 or 0. In the sports betting industry binary options are also popular – win or lose. In other words, there are only two possible outcomes. There is some basis to this all or nothing description of binary options trading. Here’s a short explanation of how it goes.
Take the price of any asset at any point in time. You make an intelligent guess on whether this price will increase or decrease over a specific period of time and bet $100 that you guessed right. If you are you win back your bet and plus a pre-agreed amount. If you’re wrong you lose almost all of your $100.
Of course it’s not as simple as that. In fact, there’s serious math behind binary options and people who engage in binary options trading, like all others involved in financial markets, are pretty confident that their numbers are better. Because in a single binary option trade, the outcome for the participants is also binary. One loses, one wins.
Let’s get a bit more technical than the simple explanation above. As currently practiced, binary options trading involves three main components.
First, there is an underlying asset, the future value of which becomes the basis for the trade. This asset can be the price of a specific company’s stock. It can be a traded commodity such as gold. Recently, there was an industry filing at the Commodities and Futures Trading Commission to allow exchanges to offer binary options for future box office receipts of certain films.
Second is the direction of trade. This is your guess of what the price of the asset will be at a specific point of time in the future and you make your trade based on whether this price will be above or below the current price at the time that the binary options contract was made. Third is, of course, the amount you wish to trade.
A binary options glossary
Like most specialized fields, binary options trading has its own jargon. These words are borrowed from the more established practice of commodities and futures trading, and gives binary options an aura similar to that of derivatives.
Current price. The price of the underlying asset.
Strike price. The price of the underlying asset when the binary option is purchased.
Expiry price. The price of the underlying asset at the time of expiry of the binary option.
Call option. The right to buy. In binary options trading, the purchase of an offer is an exercise of the option. In American exchanges this is termed as “Finish High” because the motivation behind a call is the probability that the price of the asset when the contract expires will be higher.
Put option. The right to sell. This is also exercised when the offer to sell an option is taken. This is called “Finish Low” in American exchanges because a put is based on projections that the price of an asset will be lower when the contract expires.
In-the money. A successful trade wherein a call option expires above the strike price or a put option expires below the strike price.
At-the-money. A trade in which the price during expiration is identical to the level during purchase. In some binary options contracts, such a scenario requires the initial investment amount to be fully returned to the customer.
Out-of-the-money. A failed trade wherein a call option expires below the strike price or a put option expires above the strike price.
Essentially, “options” is a misnomer for these types of transactions. “Lock” (another type of derivative) would have been the more appropriate term because once the deal is sealed, both buyer and seller are obliged to comply with whatever conditions were agreed upon to take effect at the contract’s expiry.
One other thing to remember is that trading in binary options only involves the price of underlying asset, but not the asset itself. You might be trading binary options for the price of Google or Apple stocks or gold, but there is no assumption that the seller owns any of these assets or that that you will when the contract expires.
Fixed risk and reward. Most binary options are Fixed Return Options (FROs) in which the gains and losses (the risk-reward ratio) are predetermined. You know exactly what you’ll earn should you be in-the-money, or what you would otherwise lose if you happened to be out-of-the-money. In a $100 trade, for example, many options offer a return of 81% for a successful trade. Many also offer to return 10% of the purchase amount should your trade be out-of-the-money.
Capped risk. You will never lose more than what you’ve invested, which is all too possible in other investments like foreign exchange or real estate.
Assured reward. By the same token, gains are not dependent on the price of the asset during expiry. Regardless of whether the increase in price is a fraction of a point or double the strike price, the winner gets the entire payoff amount.
Simpler to understand. In binary options trading you only need to sense the direction of the price of the asset you’re trading. With regular options, you need to know both the direction and the magnitude of the price.
High level of sophistication. While easier to understand than most options, binary options still offer enough freedom for the application of sophisticated investment strategies. Investors in the forex market use binary options to hedge against their currency investments by investing in an opposite direction to their traditional forex position. Regardless of whether prices rise or fall, they’ll have their losses covered or might even profit from their binary options position.
Shorter durations. In some exchanges, many contracts close within the day. Some durations last for only an hour so the gratification (or mortification) is instant. It is possible to participate in many options within a single trading day.
Potential to profit from both falling and rising markets. In regular stock and commodity markets, money is made only when the price of the asset is rising. Binary trading allows an investor to absorb some of the market’s risk and make money regardless of whether prices are falling or rising.
Access to multiple markets. From a single account, you can have access to a wide range of markets and asset classes including forex, shares, commodities like oil futures and stock indices.
Binary options can either be cash-or-nothing, where a fixed amount of cash is paid out. It can also be an asset-or-nothing option where instead of cash the value of the underlying asset is paid out. Aside from these basic types, there are other more exotic binary options that are a bit more complex but follow the same general concept.
Barrier options are options that depend on a specific price level for their existence within the duration of the options contract. They can disappear (knocked out) or appear (knocked in) when a specified price level is breached. In partial barrier options, the price is monitored only for a specific window within the duration.
In a double barrier option, there is both an upper and lower price barrier and the double knock ins are activated or a double knockout terminates the option if any of those barriers are hit. The more complex double barrier binary option, of which there are 28 types, combines the characteristics of both barrier and binary types.
As with any other form of investment, risk is inherent in binary options. In fact, websites that guarantee returns are the ones you should stay away from. There have been complaints of payoffs not being remitted to bank accounts, so you’ll need to do due diligence before committing. The best idea is to always go with one of the best binary options brokers that you know are legitimate and reliable.
If you’re serious about trying binary options trading out, selecting a reputable trader is the first critical step. There has been a proliferation of trading websites online and it can be quite confusing to know which is legit and which is not. Start with traders registered with the Chicago Board Options Exchange (CBOE) or the American Exchange (Amex) to be sure that the firm you’re dealing with is subject to regulation. Fixed return options are more common in Europe and are traded in European exchanges heavily, thus the nickname European options. There have been reports of Europe-based sites engaging in unauthorized binary options trading.
The financial crisis of 2008 has awakened every American to the very real threat Wall Street presents to their personal financial health. The clamor for financial reform has resulted in the Dodd-Frank Act being passing into law in 2010. However, regulation for binary options trading is not explicit in the implementing rules and guidelines although proposals for rule changes have been discussed in the Securities and Exchange Commission (SEC) and predate the creation of the Dodd-Frank Act. For now and until the rules are in place, prudence in this investment area will always be your biggest safety net.
Yes, if you have the stamina to monitor prices closely, the diligence to study the history and performance of the underlying asset you’re trading, and no past history of compulsive gambling.
Forbes columnist Gordon Pape issued a strong warning against binary options. He claims that this form of trading appeals to the online poker crowd and market junkies who tend to be more exuberant in taking chances than the ordinary investor. In fact, he refuses to acknowledge binary options trading as legitimate investment. He insists that it is a pure gambling activity where the odds are stacked against the investor.
Gordon Pape claims, as do others, that you need to win 54.5% of the time to just break even. For some, these odds are good enough, even if the house gets the better deal. For the house, it’s like having hundreds of slot machines that won’t ever pay out a jackpot. For the investor, on the other hand, binary options multiplies his chances of winning each time he cranks the machine. Not the jackpot, maybe, but big enough if one keeps at it and does the homework.
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