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A binary option is one of the types of options where a trader opens or does not open a position at the price of a financial asset, and the profit is all or nothing. Because of this feature, binary options are more easily understood to trade than, say, traditional options.
Binary options are a settlement contract like European-style options in the sense that they can only be exercised on the expiration date. If they become in-the-money options at expiration, the buyer or seller of the options receives a predetermined dollar amount. If they become out-of-the-money options, the buyer or seller gets nothing. This is their simplicity in assessing risk and reward. Unlike traditional options, full profit payout on binary options is ensured regardless of how high (or low) the price has risen compared to the strike price of the option.
Despite the term “all or nothing,” depending on the actual trading platform, “nothing” can actually mean “something.” This means that at expiration, the option holder can actually receive a certain amount of payments, even if the option has expired out of the money.
Very often you can come across a different name for binary options. In the foreign exchange market, binary options are known as digital options.
- Explore two kinds of options
A binary options trader must predict the expected direction of the underlying asset price movement. On most platforms, these two options are called put and call. A put option is predicting a fall in the price of an asset, while a call option is predicting an increase in its price. Unlike traditional options, you do not need to know the amount of movement. Instead, it is only necessary to correctly predict whether the price of the selected asset will be higher or lower than the strike price. If an investor has his own opinion about the quality of the underlying asset and wants to trade, he may well be trading binary options.
- Decide on your position
Assess the current market conditions surrounding your chosen asset and determine if the price is likely to rise or fall. If your intuition turns out to be correct at the expiration date, you will receive the clearing price of your contract. The profitability of each winning trade is determined by the broker’s decision, and this amount is always known in advance.
- Find out how the contract price is determined
The price of a binary options contract is roughly equal to how the market perceives the likelihood of an event occurring. For example, if the clearing price of a contract is $ 100 and the last trade position on the contract was $ 96, then this is an indication that approximately 96% of the market thinks this event will happen and the contract will end up in the money.
- Learn about the advantages of trading binary options over trading traditional options
- Binary options, as a rule, are easier to trade, because for this it is enough only to predict the direction of the price movement of the underlying asset, while to trade traditional options, in addition to predicting the direction of price movement, it is also necessary to predict the amount of movement. The assets themselves are never actually bought or sold, therefore, selling an asset and placing stop-losses is not part of the process.
- Binary options always have a controlled risk to reward ratio, that is, the risk and reward are always known in advance at the time of contract acquisition. Traditional options do not have specific risk and reward boundaries, and therefore gains and losses can be unlimited.
- Almost all trading and hedging strategies are available for binary options, which can be applied to traditional options trading as well. To improve the accuracy of forecasting price movement, you can use both fundamental and technical analysis.
- Unlike traditional options, the payout amount is not proportional to the amount the option is exercised “in the money”. If the binary option ends in the money, even by one tick, the winner receives the entire fixed profit.
- Binary Options offer short term contracts. In some markets, binary options contracts are completed multiple times during a trading day, while in others they can last up to a year. Some brokers provide contracts as short as thirty seconds. This gives the trader several investment opportunities and flexibility as the markets change over time.
- Check all transaction costs for binary options
Brokers working with binary options, do not take any commission for opening a position, and also do not charge any additional commissions. What percentage of the time do you consider the most suitable for making a profit from binary options? How different are the terms (for example, “strike price”) for one of the parties to the transaction you are considering and for the other party (the reverse transaction)? If they are very different from each other, one could successfully predict that the underlying asset will move very differently from the sellers’ forecast of the option – usually slightly between the terms offered by the different parties to the transaction – which is unlikely to occur. In very rare cases, the market will be able to consistently outperform this forecast, hence high transaction costs can easily offset profits.
- Always conduct a market analysis before opening each position. There are many factors to consider when deciding whether the price of an asset will rise or fall over a period of time. Without analysis, the risk of losing money increases significantly.
- You need to know how to interpret the price of a binary option. The price at which a binary option is traded is an indication of the odds as to whether the contract will be exercised in the money or out of the money.
- Before making your choice, carefully select several brokers. Each broker is going to provide their own trading platform, contract duration, assets, ROI, and training materials. Each of these elements can have an overall impact on profit potential.
- Be clear about the relationship between risk and reward – in binary options trading, risk and reward go hand in hand. The less likely it is that an option will be exercised “in the money”, the greater the profit associated with it. A smart investor, before opening a position on a contract, understands and evaluates each contract in terms of these two components.
Let’s look at an example. A foreign exchange investor foresees that the USD is strengthening against the JPY and wants to hedge his risk in an attempt to protect his Japanese yen investment from falling in value. He can do this by buying 10,000 binary options contracts on Nadex that say the USDJPY pair will trade above 119.50 tomorrow at 4:00 pm ET. If his analysis is correct, and the USD does indeed strengthen against the yen and rise above 119.50, then 10,000 binary options contracts will close in the money and he will receive a full payout of $ 1 million. If the investor paid $ 75 for the contract, then on each contract he will earn $ 25, i.e. his total profit will be $ 250,000, and the rate of return on his investment will be 33%. However, if the yen is below 119.50 by this time,then 10,000 binary options contracts will close out of the money. In this case, the trader will lose the original investment in binary options, but this loss will be offset by the gain on the value of his Japanese investment.
- Know when to exit a position. An intuitive trader acts quickly when he feels that his binary options contract expires out of the money. Example: You have a $ 75.00 silver contract and feel that it is expiring out of the money. Instead of holding it until it expires, sell it at $ 30.00 – neutralizing your open positions will help you manage your losses (i.e., losing $ 45.00 instead of $ 75.00 once you are satisfied that your option expires out of the money).
- Have information about your underlying asset. The financial value of binary options is derived from the underlying asset. Before investing in binary options, make sure you have complete information about the underlying asset and the related financial markets, in particular the market in which the asset is traded.
- When trading binary options, try to avoid “bonuses”, because in this case the broker can block your money until you receive a profit in the amount of a certain lot from the deposit amount + bonus.
- Remember that there is financial risk involved in this type of trading. There is no guarantee that even in this type of trading you will make any specific amount of money.