Are Binary Options The Right Choice?
Many investors are curious about binary options; they hear everything from ‘it’s a great opportunity’ to ‘it’s only for the big risk takers’. Most traders know very little about binaries. Probably the best way is to differentiate regular exchange traded options from binary options is to compare their similarities and differences.
On Exchange Binaries vs Standard Options
One of the biggest differences is that the maximum risk and reward are clearly defined before placing a trade. Traders know ahead of time the value of the trade at expiration. When trading standard options, there is always limited risk but the reward potential is variable and unlimited. As an option seller, risk exposure to the trade is unlimited with the reward limited to the premium sold.
What other trading instrument does this? This is very valuable information for any trader especially a premium seller.
Both binaries and regular options are in fact derivatives of underlying markets. The regular option consists of a premium made up of intrinsic and extrinsic values. The premium pricing has no value limitation relative to the strike / underlying price differential. As for the binary, the pricing is bound within a trading range of 0 to 100. It could be said that a binary that trades at 33 is carrying a premium, but it’s also the market’s assessment of the probability that the binary statement will finish in the money at a 33 percent chance. Additionally, with binaries the seller never receives premium and there is no separate option chain for puts.
Buying a binary is similar to being buying a call, so the initial cost would be the trade price and the goal is for the price to finish at 100. The binary seller would be short at the trade price and wants the trade price to finish at 0. Selling a binary is similar to being long a put where the initial trade is a cost which is the difference between a trade price and 100 so the combined costs of the buyer/seller equal the $100 expiration payout.
The binary price trades between 0 and 100 based on the relationship to the strike price and underlying price. If the underlying is trading at or near the strike, then the binary price should be approximately 50. Here, neither the binary buyer nor seller has much of a trade advantage. If the underlying rallies over the strike, then the binary price will be greater than 50 increasing the initial cost of the buyer and decreasing the cost of the seller. If the underlying sells off below the strike, then the binary prices are below 50, the initial costs are reversed.
Of course, like regular options, time and the price differential between the strike and underlying will be the driving force to the binary pricing.
Binary Option Trades
Let’s suppose that a trader thinks the E-mini S&P 500 futures will close above 1929.60 at 3:00pm and the current market is trading at 1926.25 with 50 minutes left before close. Well, there just happens to be a binary strike at 1926.25 which is based on the E-mini S&P 500 futures, trading at 18.50 and expiring at 3:00pm. Buying the binary represents a bullish position with the belief that the ES will finish higher than 1926.25 at expiration.
On this trade, the trader is risking $18.50 to make $ 81.50 return (not inclusive of exchange fees) if they’re correct at expiration. By entering the trade, a trader is giving up 3.35 points of edge where they need the underlying market to rally within 50 minutes. When entering, a trader must consider if this make sense or not given their view of the anticipated underlying movement within the timeframe.
If this is an exchange traded binary, then traders have the option to close out the trade early to take a quick profit or cut losses. However, the binary is only worth $100 per contract at expiration.
At expiration, it’s for all the marbles, the statement is either right or wrong!
Who Guarantees These Trades?
Binary options come in many forms; some of them are over the counter (OTC) and are only guaranteed by the counterparty. Traders should check with their clearing houses to see if this type of trade is suitable for their investment needs. The OTC market is fraught with danger for the retail trader, it is probably best to leave that market to the big boys.
Exchange traded products exist in the U.S. and are regulated by the Options Clearing Corporation (OCC), the CFTC, the SEC and the exchanges themselves.
Currently they are traded at the CBOE, AMEX and the NADEX.
Are Binary Options Suitable for a Retail Trader?
The answer is absolutely yes, but only for traders who can handle the emotional loss of 100% of their premium on any individual trade.
How Much Capital is Needed to Trade Binary Options?
Very little capital is needed to start trading them.
Even with as little as $1,000, a trader can begin to trade them. The key to this type of investment is that it must be risk capital that will not change the trader’s lifestyle if they lose it. Trading always has risk and with that comes swings in equity.
The key to making winning trades in this market is the same as any market, sufficient risk capital and discipline!