What are Binary Options? All You Need to Know

What are Binary Options?

Binary options are financial instruments that allow traders to speculate on the future price movement of an underlying asset. Unlike traditional options, the contract structure of a binary option is quite simple as only one of two outcomes can ever exist — you either make a fixed profit or lose your initial investment. This is where they get the name “binary” from.

While some of the instruments can be traced back to the 1970s, this marketplace has so much evolved especially when online trading facilities were developed in the early 2000s. Today, binary options have gained massive traction worldwide. However, their regulations vary significantly between different countries and their jurisdictions.

Understanding Binary Options Basics

Time and price are two essential elements of binary options. By definition, binary options offer instruments where participants have the option to speculate the future price movement — whether they will be above or below a given price level. This price level is called the “strike price,” at a given point in the future, called the “expiration time.”

Let’s go in-depth with the elements of a binary option contract.

The Underlying Asset

The financial instrument on which your binary options trade would be based is called the underlying asset. This includes, but is not limited to;

• Stocks: Apple, Amazon, Tesla
• Stock indices: Nasdaq Composite, S&P 500
• Commodities: Crude oil, Gold, natural gas
• Currency pairs: EUR/USD, GBP/JPY, USD/CAD
• Cryptocurrencies: Ethereum, Bitcoin

Strike Price

The strike price is usually a predetermined price level used to reference your binary options trade. It is expected of you to predict the outcome of an underlying asset at an established expiration time, whether it will be above or below the strike price. For example, if the market price of gold is $1,800 per ounce and you wish to place an option call for $1,810. You simply have to predict whether the price of gold will be above or below when the date of the contract expiry arrives.

Expiration Time

This is the date and time of settlement in a binary options contract. The expiration times range from as low as 60 seconds to as high as several months, depending on the nature of the binary option you are trading and also on the broker.

Short-term binary options, such as the 5-minute and 15-minute expiration are further classified as the “turbo” or “high-frequency” options. On the other hand, the longer-term ones with several hours or days of expiration are called “classic” or “long-term” options.

Payout

In an in-the-money binary option, the payout is usually a fixed amount, e.g., $100 or multiples of $100. You get a full payout if your prediction was right, and the asset ends above the strike price at expiry. If you predict wrong, then you lose your investment. That, in essence, is the basic payout structure behind the “all-or-nothing” nature of binary options: you either get a fixed gain or you lose absolutely without a partial payout or any gradual profit/loss.

Binary Options vs. Traditional Options

While binary options and traditional options—so-called “vanilla” options—are very much alike on the surface, there are some key differences:

• Structure of the contract: Traditional options provide the holder with the right but not the obligation to buy or sell the underlying asset at the strike price. A binary option has a more simplistic “yes/no proposition.”.
• Payoff: Traditional option payoffs are variable since their value depends on the market-strike price difference at expiry, but with binary options, this amount is fixed and is decided upon prior to purchasing. 
• Risk profile: In a traditional option trade, the maximum possible loss is the premium being paid, whereas, in the case of a binary option, it is considered the full investment amount.

Given these structural differences, binary options are a more black-and-white-and potentially more hazardous-higher-reward-version of traditional options trading.

How to Trade Binary Options

1. Choose a Trading Platform

First of all, a binary options trader should seek some credible and regulated options concerning the trading platform with whom he is working. It is crucial to select a licensed broker that should be regulated by the responsible financial authorities; this could be a great way to ensure the integrity of the market, thus protecting the trader.

US binary options are therefore regulated by the Commodity Futures Trading Commission and can be traded on Commission-approved exchanges. Outside the US, binary options regulation can get a bit more tricky depending on what particular jurisdiction you are operating in. Just do your homework, and make sure any broker you are using is properly licensed and registered within the relevant regulatory framework.

2. Fund Account

Immediately after registration on one of the above-mentioned trading platforms, you are supposed to open an account for binary options trading. Most brokers allow deposit options by bank transfer, credit/debit card, and an e-wallet option, such as PayPal and Skrill.

Account minimums do vary, but many of the regulated binary options trading platforms have low barrier-to-entry requirements, and some even allow you to start trading with as little as $10 or less. This indeed makes binary options accessible for a wide range of investors — from beginners to more experienced traders.

3. Place a Binary Options Trade

The process of placing a binary options trade is rather straightforward:

• Underlying asset: The type of financial instrument you are going to speculate on, such as any stock, any currency pair, or commodities. 
• Strike Price: Choose a point out of the price, above or below, from where the expiration time is achieved by the price of the underlying asset. 
• Expiration Time: Choose a date and time when you want your binary options contract to settle.
• Call” or “Put” Option Exercise: You are buying the “Call” option when you think that it should be above the striking price at expiration and an option that you believe will be below the striking price upon expiration known as a “put”.
• Monitor the Trade and Exit: Observe the underlying asset’s price movement and decide upon letting the position expire or exit the position early if your broker provides the facility for early closure.

The most deep-rooted tips towards the success of trading binary options are appropriate development of knowledge in the markets, clear trading strategy, and continuous risk management.

General Binary Options Trading Strategies

1. Trend-Following Strategies

The very concept of a trend-following strategy presupposes an identification of what the currently dominating market tendency is and making use of it. It is just the principle to buy “call” options in cases when the asset is in an uptrend and “put” options when it’s in a downtrend.

This makes following the trend a very effective approach in binary options trading since you need only to predict the direction and not necessarily the magnitude in which the market will move.

2. Counter Trend Strategies

Most of the time, during the making of a ‘Counter Trend’ strategy in order to obtain an edge from the transient reversals or corrections, it is very usual to take the opposite side against the market trend. However, this would be a bit more difficult because there usually has to be good timing in the markets and a corresponding understanding of its technicalities.

Of these, the most popular counter-trend strategies is the “fade the breakout,” whereby you buy “put” options when the underlying breaks above a key resistance level or “call” options when it breaks below a key support level.

3. News-Based Strategies

News-based strategies are based on the principle of earning money from the market’s reaction to economic, political, or company events. This way, keeping a close eye on the news calendar and analyzing the effect of coming events means you will be able to place binary options trades looking to profit from expected movements in price.

Trading calls, that is, on an underlying stock, for example, going into the earnings announcement on an assumption of positive earnings that are announced to drive up the share price. 

4. Volatility-Based Strategies

Thus, the volatility-utilizing strategy would look to exploit not just the direction of price movement, but also the change in level of fluctuation. It may thereby indicate buying “calls” when volatility is expected to go up and vice-versa “puts”, anticipating its fall.

Another very popular volatility strategy involves a trader buying a “call” and a “put” option at the same strike and expiration—the so-called “straddle” —to expect significant price swings either high or low to result in profit. 

5. Time-of-Day Strategies

Time-of-day strategies would exploit the fact that some instruments may tend to follow predictable price patterns at particular times of the day or even the week. The following is a good example: opening, in the morning, “call” options on those indexes which traditionally rise and, during the afternoon, switching over to “put” options.

Pros and Cons of Binary Options Trading 

Pros

• Simplicity and Ease of Use: The binary options are simple to the extent that the ‘yes’ or ‘no’ proposition is clearly stated and the amount to be paid out is well-predefined. It is due to this very reason that binary options have earned far greater accessibility than a few other complex financial instruments.
• Defined Risk and Reward: Because you know in advance your potential gain and loss with binary options, you have so much more control over managing your risk.
• Affordable to the Retail Trader: Because most binary options platforms require very small deposits, it is pretty easy to access this marketplace, and this marketplace, therefore, is accessible for small account sizes of individual investors.
• Diversity of Underlying Assets: You can speculate on anything from stocks, currencies, commodities, and even indices. 
• Diversity in Expiration Time: Binary options may expire in as little as 60 seconds or as much as several months. That allows you to fit in your market outlook and risk tolerance.

Cons

• High Risk of a Speculative Nature: Binary options are classified as a high-risk speculative form of trading. If market predictions turn out to be incorrect, it can lead to high potential losses. 
• Fraud and Manipulation: Cases of fraud, scams, and market manipulation have struck the binary options market with various cases, especially those operating on unregulated platforms of the trade.
• Limited Upside Potential: Because of this limit on risk, the potential reward to a binary options trade is also capped through the fixed payout-usually something like $100 or some multiple of it.
• Regulatory Concerns: Regulation of binary options is very complex and often changing, with extraordinary differences between jurisdictions. This may indicate great uncertainty and risk to traders.
• Psychological Risks and Addictions: Binary trading is fast-moving and may involve high stakes, thus addictive for insufficiently experienced and/or impulsive traders.

Binary Options Trading Tips 

• Full Trading Plan: There will be a need to define the trading strategy that then encompasses a market analysis, the procedures of risk management, and sharp decision-making for getting in and out of the trades.
• Practice: Demo binary options trading account—practice and be patient before using your own money to invest. In that way, you will be allowed to test your strategy and hone your skills to, hence, know the platform on which you’ll carry out the trading.
• Be Cautious of Risks: Make good position sizing; place appropriate stop-loss orders and stay away from excessive leverage on a trade.
• Follow News and Market Events: The economic indications, corporate happenings, and geopolitical affairs around the world may affect your underlying assets in one way or another.
• Know common scams to avoid: be leery of unsolicited offers, promises of unrealistically guaranteed profits, and brokers who are not licensed and regulated.  
• Spread the risk over many trading portfolio systems: Of course, one would not put all one’s eggs in the same basket. The idea is to diversify across wide classes of assets, and classes of various strategies to ensure a reduction in total risk.
• Improve and Learn: Binary options trading markets are here to continue evolving over time; learn constantly, put in the research effort, and adjust your trading methodology to be ahead.

Bottom line

Opening binary options is a unique, and perhaps lucrative, chance for traders of all levels of experience to make some speculations about further price movement within a wide range of financial assets. With their newly simplified contract structure, defined risk and reward, and accessibility to retail investors, binary options can round out a diversified trading portfolio quite nicely.

Written by Ivan Bogatyrev

Business Development at FintechFuel

Writing about the exciting worlds of iGaming and the brokerage business, breaking down the latest trends and insights. Making complex topics easy to understand, helping readers stay informed and ahead of the curve.

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