Binary Options Trading Explained

Binary Options Trading

While binary options can be a legitimate financial asset to trade, investors should be aware that the Securities and Exchange Commission (SEC) has issued warnings about the sometimes fraudulent nature of the industry. A binary option is a derivative in which the outcome is limited to only two possible results – like the 0 and 1 in computer binary code. When you enter into a binary option contract, you are essentially guessing whether price will be above or below a certain level at a certain future time. Obviously, the ultimate answer will be either “yes” or “no.” Before deciding to trade binary options, you should fully understand the advantages and disadvantages of this type of trading.

The Murky World of Binary Trading

We should say upfront that all binary options dealers are not crooks, but the reality is that the generally unregulated nature of these financial assets have led many to see it as a form of gambling rather than investing. In fact, the SEC and Commodities Futures Trading Commission (CFTC) issued a joint warning to American investors that they should exercise extreme caution. With binary options, there is no brokerage. The trader is simply betting against the house, which acts as a bucket shop, never actually buying the options and sometimes manipulating prices and banking profits when the options expire.

Regulated Trading

Despite the problems just mentioned in binary trading, all dealers are not scam artists and binary options can be traded on some regulated exchanges, which offers more peace of mind that the dealer is operating a clean shop. In 2008, the SEC approved a plan for exchanges to offer cash-or-nothing binary options. The American Stock Exchange took advantage of the decision, followed shortly by the Chicago Board Options Exchange. While the wisdom of trading these options can still be debated, at least the game is played fairly on an exchange. The simple nature of binary options trading appeals to many new investors who feel overwhelmed trying to understand the intricacies of investing in traditional options and equities.

Dissecting an Options Trade

Let’s examine how an actual binary option trade might play out. For this example, we’ll assume the underlying asset is the EUR/USD currency cross in the Forex market. At noon, a trader looks at prices and finds he can buy a call option if he thinks the currency will be trading above 1.2500 at 3 pm. If he thinks it will be trading below, he buys a put option. Our fearless trader waits until 2 pm. The currency is trading at 1.2490. He thinks it will move above 1.2500 within the next hour so buys 10 call option contracts for $40 each. At 3 pm the EUR/USD is trading at 1.2505. Our trader has won, but how does he figure his profit?

Since a binary option contract is valued from $0 to $100, a winning contract is cashed in for the maximum amount. Here’s the math. The trader wins $1,000 (10 contracts expired at $100 each) but must subtract $400 (the cost of buying 10 contracts for $40 each), leaving him with a $600 profit. If his guess had been wrong, the contracts would have expired worthless at 3 pm, leaving him with a $400 loss equal to the money he spent to buy the contracts. See what we mean? This is pretty simple trading.

A trader may also choose to liquidate his position at some point prior to expiration at 3 pm. Let’s say the currency is trading just below 1.2500 at 2:45 pm, but he’s not sure it will move high enough to in the next 15 minutes to maximize return. He can get out of the position by selling his options early, allowing some profit but not as much as if he had stayed in.

The Bottom Line

Binary options appeal to many traders because the risk and reward are known quantities, and you can get into a trade for as little as a $100 deposit. Bear in mind that just because something is simple doesn’t mean it’s easy to make money doing it. This style of trading is a zero-sum game. At the end of the day, someone wins and someone loses. As with all investments, don’t risk what you can’t afford.

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