Binary Options How to Understand
A binary option is a type of option where the trader takes a yes or no position on the price of a financial asset, and the resulting payoff is all or nothing. Because of this characteristic, binary options can be easier to understand and trade than traditional options.
Binary options are cash-settled as European-style options, meaning they can be exercised only on the expiration date. If at expiration the option settles “in the money,” the buyer or seller of the option receives a pre-specified amount of money. Similarly, if the option settles “out of the money,” the buyer or seller receives nothing. This allows for a known upside (gain) or downside (loss) risk assessment. Unlike traditional options, a binary option provides full payout no matter how far the asset price settles above or below the “strike” (or target) price.
Despite the term “all or nothing,” depending on the actual trading platform, “nothing” can actually mean “something.” This means that at expiration the owner of the option may actually get a certain payout even if the option expired “out of the money”.
Very often you may encounter binary options under another name. In the foreign exchange market binary options are known as digital options.
1 Know the two possible outcomes
A trader of binary options should have some feel for the anticipated direction in price movement of the underlying asset. Within most platforms the two choices are referred to as “put” and “call.” Put is the prediction of a price decline, while call is the prediction of a price increase. Unlike traditional options, anticipating the magnitude of a price movement is not required. Instead, one must only be able to correctly predict whether the price of the chosen asset will be higher or lower than the “strike” (or target) price at a specified future time. If the investor has an opinion on an underlying asset and wants to place a trade, s/he can trade binary 0ptions.
2 Decide your position.
Evaluate the current market conditions surrounding your chosen asset and determine whether the price is more likely to rise or fall. If your insight is correct on the expiration date, your payoff is the settlement value of your contract. The return rate on each gainning trade is established by the broker and made known ahead of time.
3 Learn how a contract price is determined.
The price of a binary options contract is roughly equal to the market's perception of the probability of the event happening. For example, if a contract has a settlement value of $100 and the last trade of the contract was $96.00, it is an indicator that approximately 96%* (Amount to be credited in case the operation is successful) of the market believes that the event is going to happen and the contract will end up in-the-money.
4 Learn the advantages of trading binary options over traditional options.
Binary options are generally effortlessr to trade because they require only a sense of direction of the price movement of the underlying asset, whereas traditional options require a sense of both direction and magnitude of the price movement. No actual assets are ever bought or sold, so the selling of shares and stop-losses are not part of the process.
Binary options always have a controlled risk-to-reward ratio, meaning the risk and reward are pre-determined at the time the contract is acquired. Traditional options have no defined boundaries of risk and reward and therefore the gains and losses can be limitless.
Binary options can involve the trading and hedging methods used in trading traditional options. Both fundamental and technical analysis methods can be used to increase the accuracy of price movement predictions.
Unlike a traditional option, the payout amount is not proportional to the amount by which the option ends up in-the-money. As long as a binary option settles in-the-money by even one tick, the gainner receives the entire fixed payoff amount.
Binary options contracts can last almost any length of time, ranging from minutes to months. Some brokers provide contract times of as short as thirty seconds. Others can last a year. This provides great flexibility and almost unlimited money-making (and money-losing) opportunities. Traders must know exactly what they're doing. (See the Warning below.)
5 Learn where binary options are traded.
Binary options are enormously popular in Europe and are extensively traded in major European exchanges, like EUREX. In the United States there are a few places where binary options can be traded:
The Chicago Board of Trade (CBOT) offers binary options trading on the Target Fed Funds Rate. To trade these contracts, traders must be members of the exchange. Other investors must trade through a member. The value of each contract is $1000.
Nadex is a U.S.-regulated binary options exchange. Nadex offers a range of expiration opportunities (hourly, daily, weekly) that allow traders to take a position based on market developments. The choice is vast. Indeed, there are over 2,400 binary option contracts each day. These range from popular currency pairs (such as GBP/USD) to key commodities like gold and oil. Members' funds are held in a segregated U.S. bank account in accordance with CFTC regulations, adding an extra layer of security.
6 Check the implicit transaction costs of a binary option.
Binary options brokers do not charge any per-trade fees, nor do they collect any commissions.
7 Understand the percentages.
What percentage of the time would you have to be correct in order to profit from the binary option you are contemplating?
8 Know the terms.
How different are the terms (for instance, “strike price”) on one side of the trade compared to the reverse side? If they are significantly different, the buyer would be forced into the unusual position of having to predict the magnitude as well as the direction of a price movement.
9 Know the transaction costs ahead of time.
It is extremely rare and difficult to outperform the market consistently. That means that options traders typically have to engage in many transactions in order to gaind up with a profitable position. Consequently, a trader faces the possibility of high transaction costs and lower profits.
- Always conduct market analysis prior to each trade. There are many variables to consider when trying to decide whether the price of an asset is going to increase or decrease within a specific time period. Without analysis, the risk of losing money increases substantially.
- Know how to interpret a binary option price. The price at which a binary option is trading is an indicator of the chances of the contract ending in-the-money or out-of-the-money.
- Screen several brokers before making a selection. Each broker is going to provide their own trading platform, contract terms, assets, return rates, and educational resources. Each of these elements can have an impact on overall earnings potential.
- Understand the relationship between risk and reward. They go hand-in-hand in binary option trading. The less likely a particular outcome is, the greater the reward associated with picking it. An intelligent investor understands and weighs each contract on these two matrices before taking a position in a contract.As an example, an investor who follows foreign currency movements senses that the USD is gaining ground against the JPY and wants to hedge his risk and try to prevent his Japanese investment from dropping in value. He may do this by buying 10,000 binary contracts on Nadex which say that “USD/JPY will be above 119.50” by 4:00 PM ET tomorrow. If his analysis is correct and the USD gains ground over the Yen, rising above 119.50, the 10,000 binary contracts will expire in-the-money, yielding a total payout of $1,000,000. If he paid $75 per contract, he will make $25 per contract, which is a $250,000 total profit – a 33%* (Amount to be credited in case the operation is successful) rate of return on his investment. However, if the Yen does not end above 119.50, the 10,000 binary contracts will expire out-of-the-money. In this case, the trader would fail his initial investment on the binaries, but would be compensated by the gain in value in his Japanese investments.
- Know when to get out of a position. An intuitive trader acts promptly when he feels that his binary contract is going to end out-of-the-money at expiration. Example: You have a $75.00 silver contract that you feel is not going to expire in-the-money. Instead of holding it until expiry, selling it at $30.00 and neutralizing your open interest will help you manage the loss (by losing $45 instead of $75 once it was confirmed to expire out-of-the-money).
- Know the underlying asset. Binary options derive their financial value from underlying assets. Before investing in a binary option, make sure you understand the underlying asset. Be familiar with the relevant financial markets and where the asset is traded. Example: Silver Futures are listed on NYMEX/COMEX.
- One-touch binary options are a type of exotic option grogaing increasingly popular among traders in the commodity and Forex markets. This type of option is useful for traders who believe that the price of an underlying asset will exceed a certain level in the future but who are unsure about the sustainability of the higher price. They are available for purchase on weekends when markets are cfaild and offer outstanding payouts.
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