What Are Binary Options?

Options trading has become extremely popular among retail stock traders over the past decade. One new, controversial cousin of the traditional stock option contract has gotten a lot of attention in the past couple of years: binary options.

What Is A Binary Option?

Like a traditional stock option contract, a typical binary option contract is a bet that the price of a stock or other asset will be above/below a specific strike price at a specific time in the future. However, the key to binary options is that there are only two possible outcomes if the contract is held to expiration: profit a specific, pre-determined amount, or lose 100 percent of the investment.

Related Link: How To Understand The Simple Risk Vs. Reward Values On Nadex One advantage to binary options trading is that the risk and reward of each trade is clearly-defined. While traders can (and often do) add to or subtract from binary options positions before expiration, the risk is always capped at a 100 percent loss, and the reward is always capped at the payout percentage.

How Does A Binary Option Work?

The most common type of binary option is a “high-low” option. A typical high-low option works like this: a trader starts with a belief that a stock price will rise or fall within a certain amount of time. For example, imagine that Bank of America stock is trading at exactly $17.00 with 15 minutes left in the trading day. A binary options trader that believes that Bank of America will finish the day above $17.00 might buy $100 of binary “call” options for Bank of America with a strike price of $17.00 and a 70 percent payout.

If this trader buys and holds these options until they expire (15 minutes later), one of two things will happen: either the stock will close above $17.00 and the trader will profit $70, or the stock will close below $17.00 and the trader will lose $100. Regardless of whether the stock closes at $17.01 or $17.51, the binary option only pays out the predetermined 70 percent rate.

What Are The Pros Of Binary Options Trading?

According to Tim McDermott, General Counsel and Chief Regulatory Officer of Nadex, another major advantage to trading binary options is the accessibility and flexibility of trading. “Binary options on Nadex are very accessible to the retail trader, who can open a Nadex account in as little as 10 minutes online and with as little as $100 deposited into the account,” McDermott told Benzinga. “Traditional option accounts are much more difficult to open and typically require deposits of $10,000 or more.”

Related Link: Trading Nadex Into The News: High Level Of Importance Releases

What Are The Cons Of Binary Options Trading?

The major disadvantage to binary option trading is that the risk is always greater than the reward. Because there are typically no commission fees on binary options trades, binary option sites profit from the “spread” between the potential payouts and losses. In other words, traders must be right more often than they are wrong just to break even.

Is Binary Option Trading Safe?

In the relatively brief history of binary options trading, there has been no shortage of controversy. As recently as last year, the SEC warned investors to be careful of fraud when trading binary options. These fraud warnings were issued specifically for websites that are not subject to SEC oversight, and the SEC recommends the use of registered exchanges such as Nadex to all binary options traders.

In addition to issues with fraud, binary options trading has drawn harsh comparisons to online gambling. A 2010 Forbes piece discussed the similarities between binary options trading and casino games, highlighting the fact that binary option contracts are not directly tied to any real underlying asset and that the spread between the payouts and losses is akin to the “house edge” at a casino.

Related Link: Sleeping Well While Holding Nadex Binary Positions Overnight

McDermott told Benzinga that position flexibility and informed participants are two major differences between binary options and casino games. Once a binary options position is established, traders can trade around that position (add to, subtract from, hedge against, etc.) at any point up to expiration. This freedom to modify positions based on new information is something that is not found in most casino games that rely purely on chance. 

In addition, McDermott believes that the availability of technical and fundamental information about a stock in a transparent market means that a binary option “bet” is not strictly based on chance, unlike bets on a roll of a die or a flip of a card.

As is the case with any other financial instrument, it’s up to the individual trader to weigh the pros and cons of binary options and decide if they are a worthwhile investment.

Posted In: Binary OptionsEducationMarketsGeneralbinary optionsoptions
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