Investors look for strategies to increase their returns and get more out of their money. Options trading is a popular strategy, but not every options trader knows about binary options. Binary options are Yes/No propositions that reward traders for correctly predicting an asset's price movement. Binary options are more complex than traditional options, but that complexity can help you hedge your portfolio. This guide will explore how binary options work and what to keep in mind before getting started.
What are Binary Options?
What are Binary Options?
Binary options depend on the outcome of a yes/no proposition. A simple binary option may offer a payout if the price of stock ABC is above $33.74 at 4:30 p.m. in 2 days. The option will lose money for the investor if stock ABC is below $33.74 at that time.
The assumption is that binary options — because the outcome is either yes or no — is a 50-50 proposition.
Consider the binary option above offering a payout of $150 if the price of stock ABC is above $33.74 at expiration. If the option is below $33.74, the option buyer owes $200. The asymmetry it returns creates a disadvantage to the option buyer over time, with an advantage to the option writer. Writers may also sell options with asymmetrical payout structures (50% of your investment to you for a win, but 100% of your investment to the seller for a loss) to skew probability in their favor.
Multiple options can be used to manipulate probability theory in favor of an option buyer or seller.
Buyers must also be aware of market conditions that may favor the seller. Binary options must be held until expiration, unlike traditional options that may be sold before expiration.
Changing market conditions are more prevalent for options with a shorter expiry because sudden (sometimes unnatural) market manipulations have no time to correct themselves.
Unscrupulous brokers may also commit fraud. Unregulated brokers with no oversight may refuse to pay traders with successful bids. Other platforms may commit identity theft to take back payouts from traders using stolen financial and personal information.
Binary options also have unique characteristics that traders consider advantages over traditional options. One of the major advantages of binary options is that risk is always defined. With traditional options, you can make trades that have an infinite downside.
These options also have a wide range of expiry times — you can invest in options with a turnover time of seconds. Sophisticated traders can use fast turnover to increase returns and hedge positions with longer expiration dates. Binary options also feature high returns when compared to traditional options, especially when short time frames are considered.
Depending on the broker you choose, you can trade binary options on just about anything. There are binary options on stock prices, weather conditions, sports games and everything in between. This is an advantage because you can focus on trading options where you have an informational advantage.
Binary options traders cannot use margin for these derivatives. If you want to make a trade, you must have 100% of the capital in your account for the trade and any applicable fees.
Domestic vs. Foreign Binary Options
There are two major exchanges for binary options in the U.S. They are the North American Derivatives Exchange, often shortened to Nadex, and the Chicago Board Options Exchange (CBOE). The Commodity Futures Trading Commission (CTFC) is the regulating body licensing Nadex and the CBOE for binary options.
Outside of the U.S., most binary options exchanges are traded over the counter with no regulation from any country. Offshore exchanges cannot legally offer services to the U.S. Many of them still do offer binary options trades through cryptocurrency, using the unregulated nature of crypto to facilitate anonymous transactions between buyers and sellers.
This is not to say that all offshore or crypto-based binary options trades are scams. Brokers like IQ Option, BDSwiss and 24option.com are regulated by the Cyprus Securities and Exchange Commission (CySEC). The best binary options are usually curated from a regulated exchange, most importantly because you will be paid if you come out on top.
Best Online Options Brokers
When it comes to binary options, picking the right broker is essential. The SEC's Office of Investor Education and Advocacy and the Commodity Futures Trading Commission's Office of Consumer Outreach have issued guidance for investors to avoid binary options fraud. The FBI and the U.S. Department of Justice have also issued reports warning investors of the dangers of binary options fraud, especially from unregulated offshore entities in Israel and Brazil.
Choose your binary options trading software wisely and look through the list of online binary options brokers to ensure the best chance of success.
Getting into Binary Options Trading
On the surface, a binary choice means that the option buyer has a 50-50 chance of winning. However, these investments are more complex than 50-50 odds. Some outcomes are more likely than others, and the premiums are adjusted accordingly.
Every investment carries risk, and derivatives are often riskier than the underlying assets. Investors should assess their financial goals and risk tolerances before trading binary options. You can start with a small amount of money so the losses don't have a big impact on your portfolio.
Frequently Asked Questions
Are binary options risky?
Every investment carries a degree of risk. Binary options tend to be riskier than most assets but can produce high returns. Investors should consider their risk tolerance and financial goals before getting started.
Are binary options legal?
Yes. Binary options are legal, but you must trade them with a regulated U.S. provider.
Can you get rich from binary options?
While it’s possible to get rich from binary options, these are risky investments. Most people will not get rich from binary options. Conducting due diligence and learning more about the stock market can increase your chances of success.