Binary options are a simple way to trade price fluctuations in multiple global markets, but a trader needs to understand the risks and rewards of these often-misunderstood instruments.
Binary options are different from traditional options. If traded, one will find these options have different payouts, fees and risks, not to mention an entirely different liquidity structure and investment process.
For related reading, see: Binary options traded outside the U. When considering speculating or hedging , binary options are an alternative, but only if the trader fully understands the two potential outcomes of these exotic options. In June , the U. Securities and Exchange Commission warned investors about the potential risks of investing in binary options and charged a Cyprus-based company with selling them illegally to U.
Binary options are classed as exotic options , yet binaries are extremely simple to use and understand functionally.
The most common binary option is a "high-low" option. Providing access to stocks, indices, commodities and foreign exchange , a high-low binary option is also called a fixed-return option.
If a trader wagers correctly on the market's direction and the price at the time of expiry is on the correct side of the strike price, the trader is paid a fixed return regardless of how much the instrument moved. For a call to make money, the price must be above the strike price at the expiry time. For a put to make money, the price must be below the strike price at the expiry time. The strike price, expiry, payout and risk are all disclosed at the trade's outset.
For most high-low binary options outside the U. Therefore, the trader is wagering whether the future price at expiry will be higher or lower than the current price. For more, see What is the history of binary options? Binary options outside the U. While there are exceptions, these binary options are meant to be held until expiry in an "all or nothing" payout structure. Most foreign binary options brokers are not legally allowed to solicit U.
These options can be traded at any time at a rate based on market forces. At all times there is full transparency , so a trader can exit with the profit or loss they see on their screen in each moment. They can also enter at any time as the rate fluctuates, thus being able to make trades based on varying risk-to-reward scenarios.
The maximum gain and loss is still known if the trader decides to hold until expiry. Since these options trade through an exchange, each trade requires a willing buyer and seller. Suppose the index is currently at 1,, so by buying a call option you're wagering the price at expiry will be above 1, You choose an option with an 1, strike price that expires 30 minutes from now. You can invest almost any amount, although this will vary from broker to broker.
Each broker specifies their own expiry price rules. The broker transfers profits and losses into and out of the trader's account automatically. International brokers will typically offer several other types of binaries as well.
These include "one touch" binary options, where the price only needs to touch a specified target level once before expiry for the trader to make money. There is a target above and below the current price, so traders can pick which target they believe will be hit before expiry.
A "range" binary option allows traders to select a price range the asset will trade within until expiry. If the price stays within the range selected, a payout is received. If the price moves out of the specified range, then the investment is lost. As competition in the binary options space ramps up, brokers are offering more and more binary option products.
While the structure of the product may change, risk and reward is always known at the trade's outset. This allows traders to potentially make more on a trade than they lose - a better reward: Some foreign brokers allow traders to exit trades before the binary option expires, but most do not. There is an upside to these trading instruments, but it requires some perspective. A major advantage is that the risk and reward are known. It does not matter how much the market moves in favor or against the trader.
There are only two outcomes: Also, there are generally no fees, such as commissions, with these trading instruments brokers may vary. The options are simple to use, and there is only one decision to make: The major drawback of high-low binary options is that the reward is always less than the risk. This means a trader must be right a high percentage of the time to cover losses. While payout and risk will fluctuate from broker to broker and instrument to instrument, one thing remains constant: Other types of binary options not high-low may provide payouts where the reward is potentially greater than the risk.
While brokers often use a large external source for their quotes, traders may still find themselves susceptible to unscrupulous practices, even though it is not the norm. Another possible concern is that no underlying asset is owned; it is simply a wager on an underlying asset's direction.
The positives include a known risk and reward, no commissions, innumerable strike prices and expiry dates, access to multiple asset classes in global markets and customizable investment amounts. The negatives include non-ownership of any asset, little regulatory oversight and a winning payout that is usually less than the loss on losing trades when trading the typical high-low binary option.
Traders who use these instruments need to pay close attention to their individual broker's rules, especially regarding payouts and risks, how expiry prices are calculated and what happens if the option expires directly on the strike price.
Binary brokers outside the U. Binary options also exist on U. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
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