What Are Binary Options?
The Binary Options, also known as a ‘digital option’, is a relatively new financial trading instrument. They have however rapidly increased in popularity since being launched and are now a widely established method of investment.
Although options are not new a new concept, having been used by many banks and investment institutions since the turn of the 20th Century, they have only been made available to retail traders since 2008.
The ‘binary’ contract is an simplified evolution of the traditional option contract which was endorsed by the Securities and Exchange Commission (SEC) as a ‘cash or nothing’ binary option. Subsequently they have also been approved and dealt on both the American Stock Exchange and the Chicago Board of Exchange.
While traditional options commonly used by hedge funds and banks remain a complicated investment vehicle, the digital binary option has been designed to be both incredibly simple to understand and trade.
They take their name from binary programming where only two states exist – 0 and 1. To put this into context a trade made on a financial asset using a binary contract can only have one of two outcomes; it either expires for a profit (in-the-money) or for a loss (out-of the-money).
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Key Benefits Of Trading Binary Options
The key attraction of trading with this approach is that the contracts used offer a fixed ‘all or nothing’ payout. This provides two main advantages when trading.
1. Firstly it offers known and limited risk. The ‘risk’ is the price paid for the contract at the outset. This means that your account is never exposed to any further loss than the initial price which you pay for the contract.
Contrast this with other forms of financial trading such as spot Forex or spread betting. Here you can face liabilities on your account right up until the point that your position is closed. It is of course true that you can use stop loss levels to limit any losses, however even guaranteed stop levels from your broker can be subject to slippages in fast paced markets.
With a binary contract your maximum loss will only ever be what you paid for the contract at the outset.
2. The second, and perhaps more interesting benefit is that you earn a set profit. This means that you don’t have to call big price moves in order to make equally high profits. All you need is for the market to finish above (or below) the strike price you set when buying the contract.
The price of the asset can finish 100 ticks above your strike price at expiry or it can simply be 1 tick above. It does not matter. Either way you will receive the same payout agreed with your broker which was set at the time of buying the contract.
To illustrate this let’s look at a quick example of a trade. We will use a Call/Put (High/Low) which is the ‘classic’ option contract to show how this works in practice.
You look at the markets at 08:00 in the morning and note that Oil is showing a strong upward trend which looks set to continue. The current price is $98 per barrel.
Expecting the price to continue rising throughout the day, you place a Call Option (market to be higher than the current price) to expire on at the next hour at 09:00. You purchase a contract for $100.
Let’s assume the payout on this option is 75%.
If at the time of expiry (09:00) the Oil price is above $98 then the option is said to finish ‘in-the-money’. You make a return of 75%. The $100 you used to purchase the option is credited back to your account, together with $75 dollars profit (the 75% return on the option).
This return is gained no matter if the oil price had risen to $99 or $105. In fact it could have finished just 1 cent up from the level that you placed at.
As long as the price is higher than the strike price that you purchase the option for you will still earn the high return for your market call.
So you see, you don’t have to call big moves in order to make high profits. You can still make exceptional returns even in slow moving markets and over short time periods.
Digital binary contracts are placed through on online binary options broker. These companies deal exclusively with binaries and offer contracts on a range of the major financial asset classes.
Trading is conducted online through a dedicated web based trading platform. From here an increasing number of different types of binary contracts can be placed which allow for different price outcomes to be profited from. These include the Call/Put, Boundary and Touch digital contracts.
Contracts can be placed to run for different time periods with common expiry times being hourly, daily or weekly. In the case of some brokers you can even trade with much shorter contracts which last for just over 60 seconds.
It doesn’t matter what contract you place or on what asset. The same basic principles of fixed profits and controlled risk will still apply.