In this article, We learn about "Binary Options".Let's Go!
A binary option is a type of options contract in which the payout will depend entirely on the outcome of a “Yes or No?” or “True or False” proposition.
Don’t be intimidated! Its name may sound complicated, but binary options are arguably a simpler way to trade than traditional options or currencies.
Just like traditional options, binary options have a premium, a strike price, and an expiration.
The difference is that, with binary options, the “premium” amount for the option is chosen by the trader (usually determined by the market with traditional options) and the expiration timeframes are much shorter.
Traditional options have an expiration range of a week to a couple of years, while binary options have an expiration range of less than a minute to a few days.
These variations bring about the biggest difference, which is how a profitable trade is calculated.
But before we cover the ka-ching ka-ching, let’s take a look at how binary option trades work.
With a binary options trade, the broker will pay out a percentage of the premium at risk if the conditions of the contract are met (e.g., the market price is at or beyond your target strike at expiration with a call option).
Basically, you receive a predetermined fixed profit, regardless of how far the market moves beyond the strike price or met the conditions of the contract.
Whether it’s by 1 pip or 1,000 pips, it’s the same profit payout at contract expiration; there is no middle ground. This is why binary options are also known as “all-or-nothing” options.
How To Make Money Trading Binary Options
Now that we have a basic idea of how binary option trades work, let’s take a look at a simple example.
Let’s say, you decide to trade EUR/USD with the assumption that the price will rise.
The pair’s current price is 1.3000, and you believe that after one hour, EUR/USD will be higher than that level.
You then look at your trading platform and see that the broker’s payout is 79% on a one-hour option contract with a target strike of 1.3000.
After much deliberation, you finally decide to buy a “call” (or “up”) option and risk a $100.00 premium.
You could say it’s similar to going “long” on EUR/USD on the spot forex market.
$100.00 + $79.00 = $179.00
You gain $179.00 on your account.
As you can see from the calculations above, the risk you take is limited to the premium paid on the option.
You cannot lose more than your stake. Unlike in spot forex trading, where your losses can get bigger the further the trade goes against you (which is why using stops are crucial), the risk in binary options trading is absolutely limited.
Payouts in Binary Options
Now that we’ve looked at the mechanics of a simple binary trade, we think it’s high time for you to learn how payouts are calculated.
More often than not, the payout will be determined by the size of your capital at risk per trade, whether you’re in- or out-of-the-money when the trade is closed, the type of options trade, and your broker’s commission rate.
In the example given above, you bet $100 that EUR/USD will close above 1.3000 after an hour with your broker offering a 79% payout rate. Let’s say that your analysis was spot on and your trade ends up being in-the-money (ITM). You would then get a payout of $179.
$100 (your initial investment) + $79 (79% of your initial capital) = $179
Easy peasy, right? Don’t get too excited just yet! You should know that there’s no one-size-fits-all formula for calculating payouts. There are a few other factors that affect them.
Factors in Payout Calculations
Each broker has its own payout rate. For starters, Forex Ninja’s intel shows that most brokers offer somewhere between 70% and 75% for the most basic option plays while there are those who offer as low as 65%.
Various factors come into play when determining the percentage payout.
The underlying asset traded and the time to expiration is a couple of big components to the equation.
Normally, a market that is relatively less volatile and an expiration time that is longer usually means a lower percentage payout.
Next, the broker’s “commission” is also factored into the payout rate. After all, brokers are providing a service for you, the trader, to play out your ideas in the market so they should be compensated for it.
The commission rate does vary widely among brokers, but since there are so many binary options brokers out there (and more coming along), the rates should become increasingly competitive over time.
When a Binary Options Trade is Closed
As mentioned before, binary options are typically “all-or-nothing” trading instruments in that the payout or loss is only given at contract expiration, but there are a few brokers that allow you to close binary options trade ahead of expiration.
This usually depends on the type of option, and usually, it’s only available within a certain timeframe (e.g., available 5 minutes after an option trade opens, up until 5 minutes before an option expiration).
The trade-off for this flexible feature is that brokers who do allow early trade closure tend to have lower payout rates.
When trading with a binary options provider that allows early closure of an options trade, the value of the option tends to move along with the value of the underlying asset.
For example, with a “put” (or “down”) option play, the value of the option contract increases as the market moves below the target (strike) price.
This means that, depending on how far it has moved past the strike, the closing value of the option may be more than the risk premium paid (but never greater than the agreed maximum payout).
Conversely, if the underlying market moved higher, further out-of-the-money, the value of the option contract decreases, and the option buyer would be returned much less than the premium paid if he/she closed early.
Of course, in both cases, the broker commission is factored into the payout of an options trade when closed early.
So before you decide to jump headfirst into trading binary options, make sure you do your research and find out what your broker’s payout rates and conditions are!
3 Types of Binary Options
The main factor when talking about payouts is the type of binary option traded.
The option trade example given in the previous section is a type of an “up/down” option and is considered the simplest kind.
Predicting if a currency pair would be above or below the strike price before it expires pays the lowest return.
This averages between 70%-90% depending on your broker.
Meanwhile, there are more complicated kinds of options like the “touch and range” binary options, which have higher payouts since winning such trades tends to be harder.
From what we’ve gathered, brokers usually offer payouts around 200%-400% and a few can even go as high as 750%!
An Up/Down option can go by a few different names: High/Low, Above/Below, and Over/Under. It is the simplest and most common type of binary option.
Traders simply purchase a “call” option if they believe that the closing price will be above the strike price when the contract expires, or buy a “put” option if they think that market will close below the strike price at expiration.
The EUR/USD trade example given in the previous section illustrates how an Up/Down option typically works.
Easy enough, eh? The simplicity of this option is why Up/Down options usually have the lowest payouts.
Up/Down options typically expire within an hour or a day, but some brokers are offering options that expire in minutes. Heck, some even expire in seconds!
Of course, this could either do your account a lot of good or it can cause a whole lot of damage. Make sure you manage your risk properly!
One-Touch option trades don’t require the market to be above or below a certain level at expiration. Instead, it just needs to TOUCH the strike price at least once during the option contract period for it to be profitable.
No-Touch trades, on the other hand, require that the market price DOES NOT TOUCH the strike price during the life of the contract for a trader to make profits.
Touch trades are offered during certain times of the day, and some brokers offer touch trades during weekends that usually offer higher payouts (around 250%-400% of your risk premium) than a simple Up/Down option trade.
For example, let’s say that EUR/USD closed at 1.3100 on Friday.
Over the weekend your broker offers a call option where you will profit if EUR/USD touches 1.3450 at least once next week and a put option where you will profit if the pair touches 1.2750 at least once in the same period.
You decide to take the call option. You find that during the option period EUR/USD had reached a high of 1.3600 before it closed at 1.3050.
Since the market reached the call option’s strike price (1.3450) within the option period, you would have won the trade even if it didn’t close above the level.
On the contrary, those who took a No-Touch option on the same price would have lost their trades since the pair DID touch the strike price.
Touch trades typically work out well when volatility picks up while no-touch trades are ideal for pairs that have a tendency to consolidate.
Still not exciting enough for ya?
You can also try out Double Touch/Double No-Touch options!
They are just like Touch/No-Touch options, only with two strike prices. The asset’s price has to touch (or not touch) two different levels for a trader to win the trade.
Trading Range/Boundary/Tunnel options is a lot like playing the Super Mario underwater level wherein Mario cannot touch both the top and the bottom of the screen.
For In Range trades, the market price must stay within a predetermined range and avoid touching the two strike prices within the option period in order for your trade to be in-the-money.
Some brokers offer Out of Range options where traders can profit if the price breaks out of the predetermined range within the option period.
For example, EUR/USD is currently trading at 1.3300 and the ECB interest rate decision is minutes away.
Your broker is offering a range option between 1.3280 and 1.3320 that expires in one hour. You think that the ECB’s decision is a non-event so you bought an “in-range” option.
If the price doesn’t reach 1.3280 or 1.3320 within the option period, then you would have won your trade.
That should be awesome news for you because range options usually have the highest payouts with a few brokers offering between 200%-750%!
Range options are best used when volatility is low, although some brokers offer the option to take a risk on the idea that price WILL break out of the predetermined range.
Alternatively, a few brokers also offer options on predetermined ranges that are far from the current market price.
Market Analysis For Binary Options
Remember back when you enrolled yourself into the School of Pipsology, we talked about “The Big Three” types of market analysis. In case you forgot, they are:
- Fundamental Analysis
- Technical Analysis
- Sentiment Analysis
Why are we bringing this up again? Well, the good news is that these building blocks of analysis can also be used when trading binary options!
Trading the News
One way to make use of fundamental analysis would be to go with a trade-the-news strategy.
If you’ve gone through our lesson on this trading strategy, you would know that this is best applied to those events that usually cause a ton of volatility. The spike in volatility tends to lead to fast moves which can send price rocketing higher or plunge lower.
For binary options, this can be particularly effective when you trade simple Up/Down options.
After all, you would simply need to get an idea of how price may react to better/worse than expected data and how strong the reaction may be. You just have to be confident that the price can reach the strike price of the option that you bought.
For example, you plan to trade the Australian retail sales report. Let’s say you have a bullish bias on the results.
Chances are that a better-than-expected result will spur the Aussie to new highs, so you would look to buy a “call” option on AUD/USD.
Now let’s say that, as you expected, we saw a better-than-expected result. Luckily, AUD/USD also rose, rising above the strike price. Paycheck time, baby!
Of course, there are a couple of factors to take into consideration when playing the news.
First is the potential for volatility. When playing a news report and buying a binary option, you have to be fairly confident that the event will spark enough volatility so that price can reach the strike price and stay above/below that level.
If you try trading a report that rarely causes a ripple, you’ll be throwing money down the drain.
Second, you have to factor in the time component of binary options.
Remember, for the simple Up/Down options, the price has to be above or below the strike price at the expiration date.
When trading binary options and implementing a trade-the-news strategy, you may also want to consider going with one-touch options since the price would only have to touch and not necessarily close at a particular level.
You can also try the Out of Range options if you expect the price to move with strong momentum away from its previous range.
With this option you don’t have to pick a direction, just decide whether or not the market will move big time in one direction or another.
Love using those fancy-schmancy indicators like moving averages, Bollinger bands, and Stochastic?
Don’t be afraid to slap these indicators on your trading charts when you plan to trade binary options!
Remember, these indicators help you gauge where price action may be headed next.
These are used across all sorts of trading markets and not just spot currencies.
Just make sure you have a good understanding of how each indicator works before incorporating it into your analysis.
Studying technical levels and inflection points may also prove helpful when you trade binary options.
Let’s take a look at this example on GBP/USD.
Price has just broken down from a double top.
With this behavioral pattern, price normally continues to trade lower at a distance equivalent to the height of the double top.
One way you could play this is by taking a One-Touch trade.
If the strike price that your broker offers is somewhere between 1.5450-1.5550, which is within the height of the double top, buying a “put” option might be a setup worth considering.
Sentiment analysis is the task of measuring the market’s current “feeling” with regard to broad risk flows.
Are traders confident in buying up risky assets or would they rather reduce risk by buying safe-haven assets or going into cash? This type of analysis will prove to be particularly useful when trying to hop on trends.
Will EUR/USD break for new highs? Or do you think the trend is overdone and there’s not enough momentum? You can use sentiment analysis to gauge how the market is feeling.
If it seems that risk appetite is still at a high with no potential changes to the market themes anytime soon, then the chances are we could see the trend continue.
If you’re fairly confident that market sentiment will favor a risk-on environment, you could consider purchasing a “call” option on a risk currency or asset (e.g., Australian or New Zealand Dollar, Equities, Commodities, etc.)
On the flip side, if you think a reversal in sentiment is in play and depending on how overdone you believe the move is, you could consider purchasing a “put” option on those same risk currencies or assets.
Just as in spot forex trading, it’s not necessarily a case of choosing which type of analysis you’re going to use because they’re not mutually exclusive.
In fact, you can combine all of these types of analysis to form the basis of any trade that you take.
Fundamentals can help give you a bias as to what direction you want to take, while technical analysis will help determine the chances of the market reaching, breaking, and finding support/resistance at a certain price.
Meanwhile, sentiment analysis may let you know whether the market is in a risk-on or risk-off mood.
In the end, the key is for you to learn from all your mistakes and gain experience. Over time, this process will help you fine-tune your analysis and help you develop good trading practices.
Are Binary Options Regulated?
Binary options trading is the new kid on the block, gaining the attention of regulators only recently as it is now being offered by many brokers, both old and new to the industry.
Unlike spot forex trading, which is overseen by the CFTC, NFA, or other foreign regulatory agencies, there aren’t a lot of regulators overseeing binary options trading at the moment.
Of course, with binary options gaining popularity, the ball is starting to roll on creating regulations for this relatively new way to trade.
Cyprus Securities and Exchange Commission (CySEC) was the first regulatory body to consider binary options trading as a financial instrument back in May 2012.
In the U.S., one of the top binary options brokers, Banc de Binary, made an initiative to seek regulation from the CFTC for its operations. Other binary options brokers are expected to follow suit.
Across the globe, other regulatory agencies are also starting to keep a closer eye on binary options trading. The Japanese Financial Services Authority is drafting its regulations for Japan, the largest market for the product.
Over in Malta, the Maltese Financial Services Authority (MFSA) is making arrangements to take charge of regulating binary options brokers in the country.
In line with this, brokers will undergo an application procedure and a strict due diligence process to secure their license to operate.
Among the possible application requirements are that binary options brokers fall under the Investment Services Category 3 license and will be subject to a minimum capital requirement of €730,000.
If you’re planning to open a binary options account, make sure you do so with a regulated broker.
Regulated brokers are usually held to higher operating standards, and if you do have issues (e.g., trade execution, withdrawing funds, etc.), you have a higher power to help you resolve those issues with the broker.
Although unregulated brokers shouldn’t automatically be viewed as scammers, trading with them could entail risks such as a lack of guarantees that the firm’s operating funds are kept separate from client funds.
Plus, there will be no one to hear your case and take action on your behalf if you have an issue.
Binary Options vs. Forex
Binary options trading has long existed over-the-counter, only experiencing a massive growth spurt in the last few years.
Now, approximately 90 companies (including those who white label their products) offer some sort of binary options trading service.
So okay, it’s a growing industry… But why should you involve yourself in it?
Why should you learn a whole new type of trading when you’re already learning spot forex? Isn’t it better to something you already know?
There are many advantages and disadvantages to both binary options and spot forex.
We’ll touch upon a few and hopefully, you can determine which trading instrument may be right for your trading style.
One of the great things about binary options trading is that you always know the exact maximum gain or loss in advance.
The trader controls the premium at risk to enter the binary options trade, and that is the only amount that can absolutely be lost.
Most binary options trading service providers even allow you to cut your max loss by “folding” your trades ahead of expiration after certain types of trade conditions have been met.
In contrast, with spot forex, even with a stop loss order set, you cannot be 100% certain that you will lose only the pre-calculated amount that you risked.
While improbable, there’s always the chance that certain issues may affect your final max risk like slippage, lack of liquidity to execute a stop order at the desired price, a broker’s trading platform goes down, etc.
Trade Management Flexibility and Maximizing Reward
Aside from High/Low options, many of the binary option plays are only available at certain times of the day or week, and most times the strike prices are set by the broker.
Even if you have an idea of how a market might behave within a certain time frame, you may not have the best option available to you to play your idea.
With spot forex, you are able to enter limit orders for any price or execute a market order at any time during open market hours.
In terms of exiting open trades, some binary options brokers allow you to close options trades early, but usually only after a predetermined amount of time has passed after the option trade has opened and before it closes.
And as mentioned before, the value that is returned to the trader is based on whether the market is in-the-money or out-of-the-money and of course, with a piece going to the broker.
In spot forex, you can close your trade at any time (except on weekends with most brokers). Even if it’s one second into the trade, you can get out and book profits or reduce losses.
Finally, if you think there’s going to be a long trend and you want to maximize your profit on it by holding it as long as possible, you can do so in the spot market using scaling in and trailing stop techniques.
With a binary option, the expiration date and cap on profits limits you; you’re out of the trade as soon as you close or the option expires.
Depending on your risk and risk management preferences, either trading instrument can be good or bad depending on how much time you want to spend in front of your trading platform, how active you want to be, or what you expect the market may do.
In binary options trading, there are no additional transaction costs other than what is normally factored into the final payout.
In spot forex, the transaction cost comes in the form of a spread, a commission, or both. We’ve already discussed this in a previous chapter, but feel free to revisit the lesson and read up on it again.
Another great thing about binary options trading is that you aren’t limited to just currency pairs like with most retail forex brokers.
While currency pairs are the most common assets you can trade, with some binary options brokers, you may also have the opportunity to trade your ideas on a limited number of individual stocks, stock indices, and even commodities.
Surprise volatility is not usually an issue in binary options trading. Any trade you take can weather the volatility caused by certain events.
Provided that your view turns out to be correct, you don’t need to worry about the market’s knee-jerk reactions.
The max risk is still set, but so is the max reward.
In spot forex, however, sharp swings can affect the value of a position greatly and very quickly, which makes the additional task of setting up proper risk management processes very important.
The margin for error when entering a trade is very small in binary options trading.
This is due to the fact there are only two actions to take with binary options: open and close.
There are no limit orders to keep track of or to close or adjust. In spot forex, an inattentive trader may forget to place exit and/or adjustment orders, potentially creating a loss greater than he/she intends.
Binary Options Banned
Following a wave of aggressive marketing of binary options by (mainly) unlicensed brokers to novice traders in the mid-2010s, which resulted in a proliferation of scams where traders were unable to withdraw their money from a number of these brokers, many countries and regions banned binary options such as the EU, UK, and Australia.
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