Binary options have become very popular in the last few years and for a lot of good reasons.
This article will give you a simple explanation of what are binary options, how to trade them and how profits and losses are calculated.
When I first heard of them I didn’t “get” what they were about. But once you look at them a bit more closely you will realize they are incredibly simple to understand and trade.
In a nutshell are you are doing is making a bet that a tradable, whether is a stock index, stock, commodity like gold or a currency pair will close above or below a certain price by a certain time and date. So either it closes above a certain price or it doesn’t, that’s why it’s called binary. Only one of two possible things can happen.
This makes them simple to trade. Unlike a traditional option where you have to take into consideration:
- Strike Price
- Interest Rates
- All of the “Greeks” Delta, Vega etc
- Time frame whether it’s a weekly or monthly
- In the money, out of the money or at the money
All of these factors will determine the price of the option and your chances of profiting.
With a binary option, it is usually is a very short term bet (same day but could be longer) that whatever the underlying asset is, will it be above or below a certain price by 1:30pm. (I am using the typical expiration time from Nadex)
What confused me was what the buy or sell price meant. The simplest way to look at it is, what are the chances of the “event” happening.
Lets assume you are placing a trade that gold will be above 1150 and you can buy the option at 70. This means that all traders who are in this trade think that there is a 70% chance of it closing ABOVE 1150. That’s it. On the flip side traders are thinking that there is only a 30% chance of it closing BELOW 1150.
If you think gold is going to close above 1150 on the day you are making your trade, you would buy the option at 70. Usually each contract is worth $100. So to buy one contract in this example it would cost $70 plus a commission.
Here is an actual ticket screen from Nadex. The bid is 43.50 and the offer is 49, so as a rough estimate, there is a 49% chance of the EUR/USD being above 1.2980 at 3pm.
An options value will be between 0 and 100. So if the EUR/USD does close above 1.2980 at 3pm the value of your option is 100, if it’s not the value goes to 0.
Binary Options are available on many different asset classes, here are some examples of what is available to trade:
- Indices – Such as Nasdaq, Dow Jones, FTSE, Nikkei and many more
- Forex – Combinations for all the major currencies such as USD, EUR, GBP ,JPY and AUD just to name a few
- Commodities – Gold, Silver, Oil, Corn, Coffee and several more
- Stocks – Over 50 of the biggest and most interesting companies in the world from a variety of industries are available in the Opteck asset list, amongst them – Google, Deutsche Bank, Coca Cola and many many more.
Here is an example trade:
It’s the first Friday of the month and you believe the employment report will miss forecasts and as a result gold will take a hit and go down. In this example the underlying gold futures market is trading around 1788.
So in this example gold is trading at 1788 and you are buying a binary option that will pay you if the price of gold is ABOVE 1794 or $6 away. So remember the price you are buying it at, in this case 21, means that traders are saying there is a 21% chance of gold closing above 1794.
You are buying 10 binary option contracts at 21, so this means if you are right you would make $790. To figure your profit all you do is subtract 21 from 100 and you get 79. Since you bought 10 contracts that would be $790.
Your maximum loss is what you bought them for. In this case $210. You can never lose more than you invested.
This all done for you on your entry screen, so you don’t have to do this this but it’s good to know how they are doing it.
What’s important to note on the screen shot above is the spread. You can see a 16 and 21. They difference is the spread, this is how the binary options brokerage makes their money. They will make $5 per contract.
The opposite of this trade would be if you SOLD the option. In this case you be selling at the bid of 16. (see screenshot above) So if you sold 10 contracts you would collect $160. Your maximum loss would be the difference between 100 and 16 so you would LOSE $840 in this example.
The reason you are losing more than you invested is because of the probability that gold is most likely NOT going to close above 1794. So even though you would lose more than you invested you have a very high probability you will be right.
Here is another example to make it clear:
The Dept of Labor is releasing the GDP number today and think that it will come in below expectations and silver will fall in price as a result.
In this example the underlying silver futures market is at around 32.15
In this case silver is ABOVE 3210 and is now trading at 3215 so silver will have to drop at least 6 cents for you to profit.
Since you are SELLING the option here at 64 you will collect $640 in premium (64 x 10 contracts). So if silver DOES CLOSE above 32.10 you will be wrong and lose the difference between 100 and 64 which is 36 so since you sold 10 contracts you would lose $360.
Now if you think the price of silver will stay ABOVE 3210 you would BUY this option. It would cost you 69.50 or $695.00 for 10 contracts. Your max loss would be $695 and would make $305. Remember just subtract what you paid from 100 so 100 – 69.5 = 30.5
Important: keep in mind you always sell at the bid (the lower price) and buy at the offer (the higher price)
While binary option trading is very simple to do and understand, that doesn’t make it easy to profit. Just like there are services to help you with stock trading, there are services that will help you with binary options. They will give you specific recommendations on what binary options to buy and sell.
I would highly recommend using one at first, at least until you learn how to do it on your own.
As far a binary options broker, the only one I would consider is Nadex. They are the only broker regulated by the CFTC. So they are held to a higher standard than other brokers that are not. Not to mention the trading platform is intuitive and easy to use with plenty of options to trade.
If you are looking for some recommendations on services for swing trading stocks, click here for my reviews.