Most trader and investor behavior boils down to a simple kind of question: yes or no?
Will a company beat earnings, revenue, or growth expectations?
Will a biotech firm receive approval for a new device or drug?
Will the economy continue to expand and boost blue-chip stocks?
Unfortunately, investing is rarely based on just one of these yes-or-no propositions.
For example, a company may beat expectations, but the economy is shrinking, and a general outflow of investor funds drags shares down.
However, there is a new way to trade off of simple yes-or-no questions. It's called binary options.
A New Way of Investing
Binary options may not be a familiar term, and there is a good reason for that: they are about as new as it gets.
They weren't introduced until 2007 by the Options Clearing Corporation and weren't approved by the Securities and Exchange Commission until 2008.
In May 2008, the American Stock Exchange launched the first binary options, and the Chicago Board Options Exchange followed suit in June 2008.
Binary options are very simple to understand on a basic level. They are designed to give you a fixed amount of money if you are right, and nothing if you are wrong.
However, it can be more complex to choose exactly what you want to trade.
These trades involve an underlying asset, a strike price, a bid and ask price, and an expiration time.
These options are valued somewhere between $0 and $100 for each contract. If you are right when the binary option's time limit is hit, you get $100. If not, you get nothing, and the money goes to whomever you bought the binary option from or sold the binary option to.
Matching buyers and sellers is done automatically, just like a stock market.
Until the option's time is up, the price will fluctuate. Just like stocks and most assets, there are bid and ask prices, which will differ.
The bid is what people are willing to pay to buy the option (those who think the underlying asset will close above the set price), while the ask is the price people are willing accept to sell the option (those who think the asset will close below the set price).
The options can be traded up until they expire, so you are not locked into a position as soon as your order is filled.
Like traditional options, binary options are based on an underlying security and have various strike prices to choose from as well as various expirations.
Due to the binary (yes-or-no and all-or-nothing) nature of these options, though, they are not priced like traditional options.
A Detailed Example
So that was a bit much to go through all at once, but a basic hypothetical play-by-play should make all of this pretty easy to understand:
Let's say you look at a binary option for gold at $1,200 that closes at 2 p.m. a week from today.
Currently, the price is at $1,100, so as of now, this would be a losing bet. The options cost $50 per contract to buy or sell, and there is plenty of volume.
As a result, there are two advantages you have:
- There are plenty of people willing to sell these options and effectively bet that gold will not close above $1,200 at the expiration time.
- $50 per contract is a fair price as long as there is plenty of volume. The buyers and sellers are evenly split and are pricing in 50/50 odds.
Here is why those are advantages:
- Let's say that, instead of gold trading at $1,100, it is trading at $1,500. Very few people, if anyone, are going to sell you these binary options if it would take more than a $300 drop in gold prices within a week. No new options will be sold by others, and those that own them will hoard them.
- Bid and ask prices normally are pretty rational, but if volume is low, they can stop resembling a decent approximation of risk. If only one person was willing to sell the binary options for $95 each, you could only make $5 and could lose all $95, while they risk $5 and could make $95. The potential payoff isn't worth it.
Back to our example. So you've just bought the gold options with a $1,200 strike price and an expiration at 2 p.m. a week from now.
As the week goes by, the price of gold fluctuates. When it drifts up to $1,150, your options are worth more. More people can see how gold could add another $50 and are willing to pay more to take that risk.
When it drifts down to $1,050, they are worth less, because people believe there is more risk and they are not willing to stake as much money on the odds of gold making it above $1,200 before the expiration.
As the week comes to a close, one of two things will happen:
- You were right: Gold prices steadily climb past $1,200, and the value of your options steadily rise. When your options expire, you get $100 for each contract.
- You were wrong: Gold prices sink, along with the value of your investment. Your options expire, leaving you with nothing.
When There Are No Easy Answers
Remember, you do not have to hold these options until they close. Yet in this hypothetical example, you just held them until they expired regardless of whether it was shaping up to be a winning or losing investment.
This opens up a slew of actions you can take. Constantly reevaluating your position may convince you that gold isn't going to close above $1,200 a week from now after all.
Depending on where the gold price and the value of your option is at the moment, you may decide to sell the option to someone else before it expires.
If the price of gold goes up and is approaching $1,200, but you think it will reverse before the end of the week, you may want to sell the option to someone else for a slight profit and remove the risk of an all-or-nothing expiration.
If the price of gold is gradually sinking, you may decide it is better to sell your option at $25 when you bought at $50; you'll still walk away with something instead of losing your whole investment.
The price of gold may jump to $1,250 the day after you bought the option. It will not sell for the whole $100 per contract you'd get at expiration, but maybe it is worth selling to someone else for (hypothetically) $90, taking the $40 profit (you bought for $50) and removing any risk of a reversal.
There is no easy way to anticipate this with examples, though. It all depends on how far above or below the underlying asset price is compared to the strike price, the factors that are driving asset price, and the bid and ask price for the options.
Just remember that you are not locked in until the binary option expires, though you may have difficulty selling or buying it if the risk vs. reward equation is heavily skewed to one side.
Also remember that as the week progresses, if your investment is not panning out, you'll get considerably less of a return by selling to others.
The risk becomes much higher that the investment won't pay off, and while some people may pay pennies on the dollar to try and hit an unlikely homerun in the last couple days or hours, there won't be many, and the current price has to be awfully close to the strike price.
Avoid Scams and Trading Pitfalls
While well-established, well-regarded, and well-regulated exchanges have markets for binary options, there are websites popping up that are none of these.
Some have structured payouts, require sizable deposits, and have very short expiration times that effectively game the system in the house's favor, just like a casino.
One website anonymously mentioned in a Forbes article years ago gamed the system by setting up trades where the option expires in five minutes. The “trade” simply asks you to bet on the price of the underlying asset going up or down in those five minutes.
The payout is set to a return of $15 if you are wrong and a payout of $70 if you are right for every $100 you place on the line, and you cannot sell your position to anyone else in those five minutes.
With such a short time frame, you basically have a 50% chance of being right or wrong. However, with that payout, you have to be right 55% of the time to make a profit.
These are classic gambling house rules. Some people may do well, but statistically, the house is steadily collecting more than it is paying out.
The longer you play, the more likely you'll revert to that 55% mean and end up handing money over to them. The time frame is so short that no knowledge or fundamentals will overcome minute-by-minute volatility and fluctuations.
They may call this a binary option, but it is a gambling system, plain and simple. Plus, the website is not federally regulated and offers no true consumer or investor protection.
You will be far better off sticking to a trading platform like Nadex.com. It is a U.S. Commodity Futures Trading Commission–regulated exchange with segregated client funds, which is designed primarily for retail traders.
Plus, it offers free demonstration accounts where you can place hypothetical trades to see how it works and if this style of investing works for you.
And just to make it clear, we have no affiliation or deal with Nadex.com, nor do we share any information like your email address with it.
We simply feel that it offers the broadest types of underlying assets, best volume, and best security via CFTC investor protections, plus the introductory demo account allows potential investors to acclimate to its platform at no cost.
We hope this introduction to binary options helps you decide if they are right for you and points you to a safe way to get started without putting any money on the line.
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