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What Are Binary Options?
BY LEARNSTOCKS ON APRIL 16, 2013 IN BINARY OPTIONS
Binary option refers to an option contract in which the payoff is either some fixed amount of certain
asset or nothing at all. There are two types of binary options; cash or nothing binary option, and asset or
nothing binary option.
In a cash or nothing binary option, if the contract expires in-the-money, then the owner receives some
fixed amount of cash. An asset or nothing option, meanwhile, pays the value of the underlying security.
Since these options have two possible outcomes, they are referred to as binary options. Binary options
are sometimes also referred to as all or nothing options, digital options and fixed return options.
The potential return for the buyer of a binary option is certain and known before the contract is bought.
The underlying asset in a binary option can be any financial product. Just like vanilla options, binary
options have call and put options. Binary options are European style i.e. they can only be exercised at
Binary Call Options
The buyer of a binary call option is basically betting that price of the underlying asset will move above
the strike price before the specified time. In this way, a binary call option is similar to a vanilla call
option. However, the similarity ends here. While in a vanilla call option, the payoff can be unlimited if
the price of the underlying asset moves above the strike price, in a binary call option the payoff is fixed if
the price of the underlying asset moves above the strike price. If a binary call option expires out-ofmoney i.e. if the price of the underlying asset does not move above the strike price, the buyer of the
option contract loses his entire investment.
Binary Put Options
Binary put options are bought when the price of an underlying security is expected to fall below the
strike price. Just like a normal vanilla put option, a trader buys a binary put option if he is bearish on the
underlying asset. Just like a binary call option, a binary put option also pays a fixed return if the option is
in-the-money at the time of expiration.
Where are Binary Options Traded?
Initially, binary options were traded only on the OTC market. However, in 2008, the Securities and
Exchange Commission (SEC) approved trading of binary options on exchanges. Shortly after SEC’s
approval, binary options were listed on the American Stock Exchange (AMEX), and the Chicago Board of
AMEX offered binary options on some stocks and ETFs, while the CBOE offered binary options on the
Volatility Index, known as VIX, and the S&P 500 Index.
Although binary options have moved from OTC market to exchanges, they are still thinly traded because
of their complex nature.
Binary options trading on the AMEX are referred to as Fixed Return Options (FROs).
How a Binary Option Trade Work?
Let us look at an example of how a binary option trade actually works.
Suppose Bank of America Corp. (NYSE: BAC) shares are trading at $12 on Monday and a trader expects
the stock to close at or above $12.50 at the end of the week, he will buy binary call options. Let’s say he
buys, 10 binary call options at $100 each. Assuming that the payout is 70%, if the price of Bank of
America shares rise above that level by expiration, then the option contract is in-the-money and the
buyer of the contract will receive $1000 X 0.70 = $700 for the 10 option contracts. The initial investment
was $1000 and the trader made a net profit of $700 on the trade.
Now let’s look at binary options from a put buyer’s perspective. Suppose a trader is bearish on Citigroup
Inc. (NYSE: C) shares, which are trading at $40 at the moment, and expects the price to fall to or below
$39 before the end of the week, he will buy binary put options. Let’s say the trader buys 10 binary put
options for a total investment of $1,000, expiring at the end of the week. The payout is 80%. At the end
of the week, Citigroup price falls to $38.50, then the option is in the money. The buyer of the binary put
option will make a net profit of $800. ($1000 X 0.80).
Binary Options Vs Traditional Options
While there is significant trading in traditional or vanilla options, binary options are thinly traded even
though they offer some advantages to a trader. One of the first advantages of binary options is that they
may expire at any time interval unlike vanilla options, which expire at monthly or quarterly intervals.
The payoff in a vanilla option varies by how much the value of the underlying asset changes from
opening to closing. On the other hand, the payoff for binary options is fixed. A trader buying binary
options knows beforehand how much money he will make or lose.
Binary option trades can be classified into three main types; High/Low, In/Out, and Touch/No Touch.
A High/Low trade, also called Up/Down trade, basically refers to a type of trade in which the buyer of
the option is predicting whether the market price of the underlying asset will end above or below the
strike price before the expiration of the contract. High or Up trade is when the trader buys a binary call
option and Low or Down trade is when the trader buys a binary put option.
The other trade type is In/Out trade, also known as tunnel trade, or the boundary trade. This type is
used to trade price consolidations and breakouts. In this type of trade, a trader sets two price targets,
forming a range. Once this is done, he will buy an option to predict if the price of the underlying asset
will stay within the specified price range or the tunnel until expiration or if the price will breakout.
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The final type of binary option trade is Touch/No Touch. In this type of trade, a trader is predicting
whether the price of the underlying asset will touch a price barrier or not. A Touch trade refers to a
trade in which a trader buys a contract that will make profit if the market price of the underlying asset
touches the set target price at least once before the expiration of the contract. If the predicted price
movement does not happen before the expiration of the contract then the trader will lose his
investment. In a No Touch trade, the trader is predicting that the price of the underlying asset will not
touch the stNow that we have understood the basics of a binary option, we will focus on how to trade
them. Binary options offer substantial returns to traders and therefore they have become increasingly
When trading binary options, a trader is basically predicting the price of an underlying asset. If the
prediction is right, then the trader can make a significant profit in a short time and if it is wrong, he risks
losing his entire investment. Although the risk in trading binary options is quite high, the potential
reward is also quite high.
One reason why binary options are attractive to retail investors is because one can start trading them
even with limited capital. For example, opening a trading account for stocks may require a trader to
start with a minimum balance of $10,000, a binary option trading account can be opened for as little as
$100. This makes trading in binary options particularly attractive to retail investors. Binary options are
not bought on margin.
Initiating a binary option trade is very simple. A trader has to simply select whether he wants to buy a
binary call option or a binary put option. Next he has to choose input an investment value. Finally, he
has to choose an expiry date for the contract before executing the trade. The strike price for the option
contract is established when the contract is bought.
Most brokers providing training videos on how to trade binary options on their website for free. Brokers
also offer traders other resources when they start trading to learn in-depth about binary options.
One needs to understand chart patterns when trading binary options. This is because, a trader is betting
on short-term price movements in the underlying asset.
It is also important to choose the best trading time. Trading in binary option will be best when there is
significant activity in the market. Although currencies and commodities trade throughout the day,
trading activity tends to be thin towards the end of the day. When trading in currencies and
commodities, it is best to trade when the different trading zones overlap as market activity is the highest
during this time.
For stocks, it is best to trade in the first few hours after market open as this is the time when trading
activity is most intense.
Trading Binary Options
Stock binary options are one of the most popular binary options. When trading stock binary options, it is
important that you are aware of the factors that cause movement in stock prices.
Stock price can move for a number of reasons. One of them is earnings reports. When a company
releases its quarterly earnings reports, there can be significant price movement. If the earnings are
below expectations there is generally a sharp decline in the price of the stock and vice versa. The crucial
thing is to be aware of the earnings release dates as stocks can be extremely volatile shortly after
releasing quarterly results. Stocks can also move on announcement of a merger or acquisition.
Always keep an eye on the news related to the underlying stock. For example, if you trading binary
options on Google, it is important that you are aware of Google’s earnings release dates, market
sentiment, and chart patterns.
Let us look at an example of how you can trade stock binary options after a major news announcement.
Suppose, Google is trading at $700 ahead of its earnings release. Now expectations are for the company
to report earnings of $6.60 per share, but Google’s earnings fall well short of expectations. Given the
earnings miss, it is likely that Google shares will fall sharply as traders will start offloading their positions.
If you are a binary option trader, then buy binary put options as the price of Google shares are expected
to slide. Suppose you buy a put option expiring in 1 hour at $700 strike price i.e. you are betting that
Google shares will fall below $700 before the expiration of the contract. Now if the predicted price
movement takes place then your option is in the money. Because most binary options are European
style, you will have to wait until the expiration of the contract to book your profit.
Risk management is one of the most important aspects of trading in any financial products. Same goes
for binary options. It is advisable that you trade no more than 5% of the account size. Suppose you have
a $2000 deposit in your trading account then it is advisable to not expose more than $100 to the
rike price before the expiration of the contract.
Choosing a Broker for Trading Binary Options
The next important thing when trading binary options is to choose the right option broker. There are
many scam binary options trading site on the Internet and it is important to separate the genuine ones
from the fakes.
So How Do You Select a Binary Option Broker?
When choosing a binary option broker, a trader needs to look at several things. First and foremost is the
issue of regulation. It is very important to find out that the binary option broker you are trading with is
regulated as this will ensure the safety of your funds.
Once, you are satisfied about the regulatory issue then the next thing to look for is customer service.
Genuine binary option brokers have a dedicated customer service department. The customer services
department should be able to provide timely solutions to traders’ problems. Several option brokers
offer live chat services and this can be very useful.
The next thing to look for is the range of trade types. The best option brokers offer all three trade types
i.e. High/Low, In/Out, and Touch/No Touch. However, some binary option brokers offer two trade types,
while some offer just one. Always choose an option broker that offers full range of trade types or at
least two trade types. Also, make sure that the option broker is not placing any kind of limitations on
trading, which can make generating a profit difficult.
The next thing to look for when choosing an option broker is the trading software. Always choose option
brokers that offer trading software, which are user friendly. If the trading platform you are using is
difficult to understand and you are having problems navigating around, then it will difficult for you to
trade. Generally complex trading platforms lead to failed trades. Therefore always avoid them and use
trading platforms that are user friendly and easy to navigate. These days, brokers are also offering
mobile versions of their trading platform, given that more and more people are now using smartphones
and tablets. Mobile version of trading platforms means that you can trade from anywhere and at any
Perhaps the most important thing after regulation is payouts. Payouts for binary options can be
different. Some option brokers offer payout of as much as 80% per trade. Always choose an option
broker that offers the best payouts and are regulated.
Cedar Finance is one of the most highly regard option brokers. Traders can open an account on Cedar
Finance for as little as $200. Account can be opened in either the U.S. dollar, the euro or the British
The broker offers a diverse selection of assets. Some of the assets include Euro/US dollar,
Euro/Japanese, gold, oil, NASDAQ, S&P Future.
Payouts can be as high as 81% on Cedar Finance.
When an investor buys a call option, he is expecting the price of the underlying asset to go above the
strike price before the contract expires. If the price of the asset moves above the strike price before the
expiration of the contract, then the owner of the contract can buy the underlying asset at the strike
price and sell it in the open market at a higher price. The profit would be the difference between the
market price and the strike price less the option premium.
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A put option on the other hand refers to a option contract in which the owner has the right but not the
obligation to sell the underlying asset at the strike price on or before the specified time period.
The buyer of the put option contract pays a premium to the writer of the option. The buyer of the put
option expects the price of the underlying asset to fall below the strike price before the contract expires.
His motive could be to profit or just hedge his position.
Where are Options Traded?
Options can be traded either through an exchange or over the counter (OTC). Generally, stock options
are traded on an exchange. Options traded on a exchange are settled through a clearing house and
therefore there is no counterparty risk.
Options can be classified on the basis of the dates on which the option may be exercised. Majority of the
option contracts are either European or American style options. Generally, these options are referred to
as “vanilla options.”
A European option may be exercised only at the expiration date of the option. For example, if you buy a
European call option on a stock X, strike price $20 and expiration data May 20, 2013. Now even if the
price of stock X exceeds $20 before the expiration of the contract, the owner of the contract cannot
exercise the option before May 20, 2013.
On the other hand, in an American option, the owner can exercise his right to buy or sell the underlying
asset at any time before the expiration date. Therefore in the above example, if the price of stock X
exceeds the strike price on May 10, 2013 i.e. 10 days before the expiration of the contract, the owner of
the option contract can still exercise the contract.
Majority of the options contract traded are either European or American.
However, there are also other option styles. These options are generally referred to as “exotic options.”
Exotic options are different from vanilla options in terms of the underlying asset or the payoff
calculation. Generally, exotic options are traded on the OTC market unlike vanilla options, which are
mostly traded on an exchange.
The different types of exotic options include Barrier Options, Compound Option, Binary Option,
Bermudan Option and Rainbow Option among others.
Your First Stock Purchase
While all of the brokerage have a somewhat unique way of letting you research stocks and enter orders
to buy and sell a stock, they are quite similar. Most brokerages will offers you rather in-depth tools to
research and find your first investment.
Once you have located a worthy stock to purchase, you can look up its quote. There are quite a few
things that can appear on a full stock quote. However, the basics are: Symbol Last Price, Bid and Ask.
For example: MSFT (Microsoft Corp.), $26.56, Bid: $26.55, Ask: $26.56. So, all you need to know to begin
is for most companies that are traded by a lot of traders throughout the day (which are most of them)
the bid and ask spread is very small. In our MSFT example it is 1 cent (26.55-26.56). When this is the case
and you aren’t buying 1 million dollars worth of the stock, you probably would never need to pay
attention to the bid or the ask. Therefore, for the simplicity of first stock trade, let’s look at only the Last
Price (which is usually somewhere between the bid and ask).
At this point you would decide how much money you wish to invest. Let us say, you want to invest about
$2700 in MSFT, at it’s current market price you would be able to purchase about 100 shares
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