If you follow financial news, you are likely familiar with the term 'binary options.' If you don't, this now popular forex phrase may sound like a bad college calculus flashback, causing you to break out in bouts of palm sweat-inducing panic at the mere thought of getting into the trading game.
But fear not. Binary options are not math. Rather, they are an investment method whose reward to risk ratio is far higher than that of other forex options.
Like all financial matters, binary options are essentially a form of odds betting wherein buyers purchase contracts that are either for or against a particular outcome. The two main types of binary options are cash-or-nothing and asset-or-nothing.
Cash-or-nothing: This type of binary option pays a fixed amount of cash if the option closes in the money.
Asset-or-nothing: This type of binary option pays the value of the underlying security if the option closes in the money.
Binary options received their name because they allow for only two possible outcomes. They are also often referred to as Fixed Return Options (FROs on the American Stock Exchange), all-or-nothing options and digital options (common in forex/interest rate markets).
A FEW EXAMPLES OF HOW BINARY OPTIONS WORK
If all of the above is still confusing - and we get that it is - here's an example:
Let's say you buy a contract for $10. This contract says that the euro will close at 1.9020 at the end of the week. If at the end of the maturity date (i.e. the end of the week), the euro has closed at or above 1.9020, you receive either a fixed amount of cash (cash-or-nothing) or the set value of the contract's underlying security (asset-or-nothing). If it closes below 1.9020 you lose only the purchase price of the contract, in this case $10.
Here is another example:
You make a $10 cash-or-nothing call on Company X's stock selling at $25 with a binary payout of $100. If the stock is trading at or above $25 on the predetermined maturity date, you receive $100. If it is trading below $25, you lose nothing except the original price of the call option, in this case $10.
TERMS & CONDITIONS
Before elaborating on the uses of binary options, we should define two significant investment terms: stops and position. If you've already been around the buy-and-sell block, this will be redundant and you should skip to the next section. If you're a financial newbie, pay close attention.
- Stops (aka 'Stop-Loss Order): An order placed with a broker to sell a financial unit (securities, commodities, currencies, etc.) when it reaches a certain price.
- Position: a commitment to buy or sell a financial unit for a predetermined price.
USES & BENEFITS OF BINARY OPTIONS
Binary options allow new traders to test their skills without risking any serious cash. They are also a great investment strategy tool for serious traders.
Binary options as insurance
Binary options can act as substitutes for stops by enabling a trader to remain in a position when the market is going against him. If he is wrong (i.e. his negative reversal of fortune was not temporary), the cost of his gamble will be greatly reduced by the payoffs of the binary options he bought in favor of the price moving against the position.
The only risk - and it is a nominal one - is whether the cost of the binary option was equal to the seriousness of the position's reversal. If that cost was substantially high, the trader could find himself over-protected, kind of like insuring a used Volkswagen as though it were a Rolls Royce headed for a million dollar collision.
Trading binary options for short-term gains
Binary options may expire in the money or at zero value, or they can be traded for short-term gains. Proficiency in employing binary options in lieu of stops requires timing one's entry and exit. This is the gambling equivalent of knowing "when to hold 'em and when to fold 'em."
Getting a leg-up by legging in
Binary forex options are also a great means of legging into a position, allowing a trader to test the temperature of a particular financial unit by metaphorically dipping his toe in the water instead of diving in. Rather than giving a market order to go long or short, the trader sets an intra-hour binary option. If it hits, the trader has a better indication of the market's strength and can enter a spot position in the same direction with greater confidence. In this way, the binary option is a signal for momentum.