Binary Options Provide Simplified Solution to Increasingly Complex Markets

Source: Think Stock

The digital world we live in – and all of the devices we crave – run on a binary number system. Series of “ones” and “zeroes” create the music we listen to, the apps we run on our phones, the programs we watch, and now they even control just about every function in our cars.

So why shouldn’t a binary system enter into the way individuals trade? It seems only natural…

In fact, it already has, and it’s arguably the easiest, fastest, simplest, and most cost-effective way to profit from price movements in:

• Currencies
• Stock Indexes
• Commodities
• Market-Moving Events

They’re called Exchange Traded Binary Options, and they allow traders to place a ‘Yes’ or ‘No’ prediction on an underlying asset or event for a defined payout over a specific period of time.

And if you think that description of binary options makes them seem like a simple way to trade, you’re absolutely right.

The simplicity of the contract itself serves as very good starting point for those learning to trade options or even for those just looking to trade the markets in general. Yet, the veteran futures or options trader can also benefit by more complex strategies using these contracts as well.

Let’s start with where.

At the time of this writing, there are three exchanges in the U.S. that list binary options. There is the Chicago Board Options Exchange (CBOE) which is an SEC regulated exchange, the North American Derivatives Exchange (NADEX), and Cantor Exchange – both of which are CFTC regulated exchanges. While all list binary options, the binary options listed on CBOE are typically designed more for the institutional trader while the contracts listed on Nadex and Cantor are geared more toward the active individual trader. For the sake of this article, the examples I use will be based on the contracts offered at Nadex; however, most of the principles apply to all of the exchanges.

So what are binary options?

Binary Options are made up of three components. There is an underlying market such as crude oil. Followed by a strike price or condition such as “>99.00”. The third component is an expiration time, for example, “2:30 PM on 11 February. So the contract in this example would look like “Crude Oil > 99 at 2:30 PM on 11 February”

This contract is basically asking the question do you think the price of Crude Oil will be greater than $99.00 at expiration time (2:30 PM on the 11^th), yes or no? (Notice, even the decision is binary?)

If you think the answer to that question is yes, you would buy the option. If you think the answer is no, you would sell the binary option.

How are they priced?

All binary options listed on Nadex have a total value of $100.00 and the price can range from the floor of 0.00 to the ceiling of 100.00 with each whole number between 0 and 100 representing $1.00. When trading binary options, it may help to think of the price as the probability of the question being answered as a yes or true.

The Easiest Way for Individuals to Trade Commodities like Crude Oil is arguably with Binary Options

Source: Shutterstock

Using our previous example, if the Crude Oil market is trading at $98.00 and we have a binary such as “Crude Oil > 99 at 2:30 PM” we may see a price where we can buy this contract at 35. In this case, the market is basically telling us it that it thinks there is roughly a 35% chance of that statement being true and thus settling at expiration at 100.

As a general rule of thumb, anytime the underlying market is trading below the strike price (condition) of the binary option, the price will be below 50 as the market typically views this as less than a 50% chance of being true. Conversely, if the underlying market, in this example Crude Oil, is trading over the strike price, the price of the binary option will be above 50 as the market will tell us that there is a greater than 50% chance of this event happening.

When buying or selling a binary option, our risk is always capped at the floor or ceiling, respectively. When buying a binary option, the worst case scenario is an outcome of zero, and so the risk is limited to the difference between the buy price and 0. When selling a binary option, our worst case outcome is 100, so our risk is capped when selling to the difference of 100 – the sell price.

In the example above, if we buy the binary contract at 35, our worst case scenario is 0 so our risk on one contract would be $35.00. If we sell a binary option at 35, our worst case scenario is 100, so our risk on one contract would be $65.00. Whatever our maximum risk is on the trade is also the collateral required to place the trade and we can never lose any more than that.

If the outcome of the binary option is true, the buyer would receive $100.00. If the outcome of the binary option is false, the seller would collect $100.00. Please keep in mind, while the payout at expiration is always $100 or $0 the trader will have to remember to deduct the cost of the trade to figure out their actual profit or loss.

All or nothing, not really.

At this point, you may be saying to yourself “This sounds pretty interesting, but how the heck do I know if the market is going to be over or under that price at that exact time?”

While much of the focus of binary options is on their “all or nothing” / $0 or $100 characteristic (after all, binary is in their name!), it is very important to note that these contracts can be actively traded in and out before expiration. Open positions can be closed early to limit losses or to lock in profits.

Let’s say, for example, you have done your analysis on the crude oil market and believe prices are going to climb higher in the next couple of hours. This belief could be based on technical analysis or something fundamental in nature such as the crude oil inventory report. Whatever the reason, you believe oil is going up.

Using the previous example of the underlying crude oil market trading at 98.00, you believe the price could move rapidly higher, perhaps as much as a $1.50 per barrel. You look to the list of binary options and see that the Crude Oil binary option to be greater than 99.00 is trading at 35.

You enter a trade which is matched at 35. As the underlying market moves, so does the price of the binary.

Say for instance, you were incorrect and the crude oil market moves lower and your binary option is losing value. You could either hold this position to expiration and risk losing all $35 per contract, or realizing you assessment was incorrect, you could try to close out early, for example, at a level of 20, in order to limit your loss on this position.

On the other side, lets’ assume you were correct and the price moves higher and is now trading above your strike price of 99.00. At this point, you could attempt to close some or all of your binary option position to lock in profit. Say, for example, you set a limit order to close your binary option position at 75 and your closing order was filled. In this case, rather than waiting and hoping that the crude oil market stays over your binary option strike price, you have now locked in 40 points of profit.

This has been just one illustration of the use of binary options. Just as there are many ways and strategies to trade all markets, so there are many markets and strategies to explore with these types of contracts. Nadex offers binary options on the most heavily traded stock indices, forex and commodities markets, with hourly, daily and weekly expirations.

Whether you are a beginner in the world of trading and always wanted to try them out, or if you are a seasoned professional looking for instruments to offset risk, binary options may be right for you. If you are interested in taking a look at how the binary options may fit in, Nadex does offer a trial account with virtual funds to give you the opportunity to try out the contracts without risking any of your trading capital.

Futures, options and swaps trading involves risk and may not be appropriate for all investors.

www.nadex.com