First listed on the Board of Options Exchange (CBOE) and the American Stock Exchange (AMEX) in 2008, binary options have become the new darling of the online financial trading world. Today, they are traded, in the over the counter (OTC) market, by traders from all over the world.
What are Binary Options?
A Binary option is essentially an exotic type of a financial derivative. A financial derivative is a financial instrument whose value is based on the value of an underlying asset. They are called binary options because they have only two possible outcomes which are In the Money (ITM) or Out of the Money (OTM). They are sometimes also known as Digital Options and Fixed Return Options (FRO) because of the fixed returns they pay out to traders.
This is also the key difference between binaries and the traditional vanilla options. The returns for traditional vanilla options are not fixed and depend on the magnitude of the price movements. The larger the magnitude of the price movement, the larger will be the profit margin or loss incurred.
Another key characteristic of binaries is their short expiration time. You can open a short term contract that expires in as little as 60 seconds, 30 minutes or one hour.
Today the types of option contracts that are available for trading have expanded tremendously. The choices include:
The classic form of binaries and the most popular one. Traders just have to determine if the price of the underlying asset will go up or down at the expiry time.
Traders have to determine if the price of the asset will touch a predetermined level before the contract expires
Traders have to decide between 2 assets and determine which will perform better in a predetermined time
For range options, you have to decide if the expiry price will remain within a predetermined price range or go beyond the range
The types of assets that are available for binary trading will vary from broker to broker. Typically, the market coverage includes currency pairs, commodities, stocks, market indices and occasionally bonds.
How to Trade
So how does one go about trading this instrument? Let us look an example of trading the EUR/USD currency pair. Let’s further assume that we expect that the price of this currency pair is going to rise within the next 30 minutes. So we look for a contract that will expire in 30 minutes. And since we are counting on the price of the EUR/USD to rise, we will purchase a Call option to expire in 30 minutes. If we think that the price of the EUR/USD is going to fall, we would purchase a Put option.
So if the EUR/USD does rise within the next 30 minutes, you trade would close in the money (ITM). If the payout ratio was 85%, this means that for every $100 that you invest you will receive a gross return of $185. Had your trade expired out of the money (OTM), you would only lose the $100 that you invested. Nowadays, most brokers offer their traders a rebate ranging from 5% to 15% for trades that close OTM.