What is binary options trading?
Binary options trading is a relatively simple way of betting on whether or not a certain outcome will occur. The name ‘binary’ (meaning ‘two’) reflects the fact that you must choose from just two scenarios – yes or no.
In financial trading, this is typically whether the price of an asset will be lower or higher than a certain level at a pre-determined point in time.
The most common type of binary option is a digital option, sometimes broken down further into ‘up/down’ or ‘call/put’ options.
With a simple call/put option, if you think the price of the underlying asset will end at or above the strike price, you buy a ‘call’ option. If you think the price will be below the strike price at expiry, you purchase a ‘put’ option.
If you are correct, the option is ‘in the money’ and pays out a fixed amount of compensation.
This compensation is typically money but in some contracts can be a quantity of the underlying asset itself.
If you are wrong, it is ‘out of the money’ and you receive nothing.
Because of this, binary options are sometimes called ‘all-or-nothing options’.
The attractions of binary options trading
Because you have just two possible outcomes to consider, binary options trading is considered simpler than many other kinds of financial trading.
Typically, all you need to decide is in which direction you think the price of the underlying asset will move.
Unlike with other forms of financial trading where your potential profit or loss is determined also by the size of a price movement, it doesn’t matter to a binary options trader how far prices have moved above or below the agreed strike price when the option expires. With binary options, a winning trade always produces the same payout.
Because of this, you have a clear picture of your risk-to-reward ratio before you enter a trade.
This is in contrast to traditional options, where profits and losses can be limitless.
With binary options, therefore, you don’t have to sit at your trading terminal, anxiously watching prices – once you have made your trade, you don’t need to check in until the contract has expired. You also don’t have to worry about applying complicated risk management tools like stop losses.
Binary options are flexible, with brokers typically offering contracts for a wide variety of underlying assets – from foreign exchange or commodities to company shares or indices like the FTSE or S&P 500.
Contracts can also run for anything from 30 seconds to several months, depending on what your broker offers. This means you can tailor your trading to your own areas of expertise or trading style.
If you’re an experienced trader in other markets, such as foreign exchange or shares, you can apply some of the skills you have already developed.
Fundamental and technical analysis, for example, can both be used to help you form a view on future price movements.
The risks of binary options trading
With binary options, it is possible to lose all the money you have invested if none of your trades are successful.
Careful money management (see Lesson 6 https://learn.tradimo.com/lessons/1278) should however ensure that you do not wipe out your entire trading account.
An example trade
All or nothing call:
The current price of Uncle's Apples shares is $10. If you think the price will go up and trade above $10 this time tomorrow, you can profit from this expectation by buying a one day binary call option.
Before buying the option you need to decide how much money you put on the trade. This will be your investment (your risk) and your payout will be a certain percentage of this amount. If the broker is offering a 50% payout, it means, if you win, you get your investment back plus 50% on top of it.
Let's say you invest $20 in a one day Uncle's Apples binary call option with a 50% payout. You come back same time tomorrow to see how your trade performed. You were right, the price is above $10 per share, that is, your option expired in the money. You get your $20 investement back plus 50%, that's $10. So you get $30 altogether.
However, if Uncle's Apples shares were below $10 when the contract expired, the contract becomes worthless. Then the option would be out of the money and you would lose your initial investment of $20.
Other types of binary option
With a ‘one touch option’, you predict that the price of the underlying asset will at some point during a defined contract period touch (reach or surpass) a certain level. If it does, you receive a payout. If it doesn’t, you receive nothing.
With a ‘no touch option’, you predict that a certain price will not be touched during the contract period, and are compensated if you are correct.
With a ‘double touch option’, you define two price levels and predict that at least one of them will be touched during the contract period. You receive a payout if this happens. If the price stays within the range of these two prices and touches neither, you receive nothing.
Note that the closing price at the end of the contract period is irrelevant with any kind of touch option. This makes them perfect for traders who believe that prices will be volatile but aren’t confident about predicting a sustained price move.
They are therefore particularly popular for trading volatile assets like foreign exchange and for very short-term trading with contract periods as short as one minute.
Although payouts tend to be bigger to reflect this, there is a higher chance that you will lose your entire deposit.
So far you have learned that:
- binary options got their name from the fact that there are only two scenarios to consider: the market ends up either above or below your target price when the option expires
- you get paid a set amount, typically a certain percentage of your investment if you are right or you lose your investment if you are wrong
- it is because of these two reasons that binary options have gained a huge popularity in the last few years
- brokers have created a variety of binary options contracts so you can take advantage of special market conditions, such as ranges, breakouts, tests of significant price levels and trending markets