In life, we know that many things are binary. There are always two sides to a story, two sides to a coin. Well, the same goes for options trading, and this is where binary comes in. Binary options have become one of the most hyped exotic financial products since the late 2010s.
So what are binary options, and how do they work? We’ll answer this question and look at the benefits and risks involved.
What is binary options trading?
Before we understand how to trade binary options, let’s briefly explore what an option is. An option is a type of financial instrument allowing you the right, but not the obligation, to trade a market at a specific price on or before a defined expiry date.
With binary options, it’s a simple ‘yes or no’ or ‘all or nothing’ proposition where you receive a fixed profit or fixed loss.
This is why it’s called ‘binary’ because there are always two known outcomes to a position. Exploring how to trade binary options is similar to betting. One of the key differences between ‘vanilla’ (or regular) options and binary trading is the requirement to buy or sell.
With binary, there is an obligation to trade, while this is reserved with options (with the only downside being a premium if you decide not to exercise the position).
A binary trade is simply a question of whether a market will be above (or below) a certain price (the ‘strike’) at a set expiration time. You make a profit if your prediction turns out correctly; you lose a certain amount if things don’t go your way.
Let’s uncover the basic components to understand when you learn how to trade binary options:
- The underlying asset: Like regular options, the traded price is derived from a real market. You can perform binary trading on a wide range of instruments like forex, stocks, crypto, metals, indices, commodities, and even economic events.
- The strike price: This is simply the price level on which the trade is based.
- The expiry date and time: Unlike conventional options, the expiration lengths with binary is much shorter, typically from 60 seconds to an hour. So, your prediction has to remain correct at any time from execution until the trade expires. At this point, your broker will either credit or debit your account.
How does trading binary options work?
The scenarios we will provide shortly cover the most basic type of binary trading known as a call/put (also called an up/down or high/low).
This kind of binary revolves around “Will the price of X be higher or lower than its current price after the expiration time?”
Let’s look at a simple example of a binary call option. Assume the strike price of a market was $1.30, with a fixed payout of $85 and a loss of $100.
Let’s also presume that the expiry time was 1 minute. If you said the market would be above the strike price after expiry, you would gain $85 (‘in the money’). Conversely, you would lose $100 if the market was below the strike price after expiry (‘out of the money’).
As you learn how to trade binary options, you’ll notice that the risk-to-reward is often skewed. Trading experts generally advocate for a risk-to-reward of at least 1:2. So, you aim to gain $2 for every $1 you risk.
Yet, many binary option trading brokers offer between 60-90% of your stake, while you always have the potential to lose 100%. This is one of the drawbacks of this trading style. However, it’s one reason many traders explore other interesting and complex binary investments with higher payouts.
- Range (or boundary): This binary option requires the trader to predict whether the price will remain in or out of a pre-defined range before expiry. Here, you can profit up to 100% of your deposit on the position.
- Touch/no touch: With this binary option trade, the speculator predicts if the market will touch or not touch a pre-determined price at any time before expiry. Returns from your stake can go up to 300%.
- In/out: This option is separated into two forms. The ends between/ends outside is where the trader predicts whether a market ends between or outside two defined price targets or ranges before the expiry.
On the other hand, the stays between/goes outside option sees the trader determine if a market stays inside or goes outside two predetermined targets or ranges before expiry.
- Ladder: This is one of the most advanced binary trading strategies, yet it can offer over 10X of your initial investment. Here, the aim is to predict the market hitting several predetermined ascending or descending strike prices.
So, a successful trade happens when the asset hits all the pre-defined levels before the expiry.
How to trade binary options
Now that you understand binary and all the different types involved, let’s look at how to trade binary options for the best chance of success.
- Understand short-term trading and risk-to-reward: As mentioned, binary options trading is based on short-lived price fluctuations. This requires a different way of analysing the markets compared to other methods.
Traders often rely mainly on technical indicators and tools on lower time frames or charts to make their predictions. However, there are other scenarios where fundamental analysis (mostly by way of high-impact news) is to used to find opportunities. This applies if you’re specifically trading options geared around economic events.
Ultimately, learning how to trade binary options is about quick thinking and making smart decisions on the fly.
Regarding risk and reward, your strategy should naturally have a higher winning percentage if you’re trading regular binary. As stated earlier, the payout is less than your potential loss. So, you need to win more of your positions to make money in the long run.
- Pick your preferred market: While binary trading rules remain the same, the traded instrument influences your success or failure. One element that determines how far prices travel is volatility.
Crypto and forex are generally regarded as the most volatile, meaning they may be the best for binary.
Some markets like stocks and forex generate the most buzz when it comes to news, which can offer you an upper hand. Regardless, you should have your preferred market before going into binary.
Most binary traders started with the spot version of the underlying asset or use binary as a secondary market.
- Find a regulated broker: The presence of scams for binary options trading is well-documented. One simple way to minimise the risks is using a regulated options dealer or provider.
Regulation means they have a license from a recognised financial services regulatory body within the country. A regulated broker enforces more trust and confidence they will treat their clients fairly.
- Practice on a demo account: Finally, as with any market, you should spend considerable time on a demo account. Platforms for binary options trading may be a little complex for less experienced traders. So, it’s crucial to familiarise yourself before going into live trading.
Benefits of binary options trading
Let’s look at the upsides of exploring how to trade binary options.
- Defined loss and profit parameters: This is perhaps the most significant benefit of binary options trading. Most traded markets use stop loss to control losses. While it’s necessary, you can always lose more than intended.
This typically happens when traders remove the stop loss or slippage occurs, resulting in orders executing at different prices than expected.
However, the parameters for loss are always known regardless of market conditions. Also, the trader will know how much they stand to profit after the expiry date. With other instruments, there is more uncertainty.
- Wide range of traded markets: With binary, you can access more instruments on one platform. This is in stark contrast when you’re trading a single security.
- Leverage: Like many derivatives, margin is present. This mechanism allows traders to make substantially more profit with a smaller balance. With binary, it’s better because the losses are more controlled. Still, the leverage is lower than markets like forex, meaning your profit potential is limited.
Risks of binary options trading
Of course, despite the benefits, you should note several downsides to binary.
- Capped profit potential: We have just alluded to this point. While knowing much you stand to lose or gain for each trade is beneficial, it puts a cap on your earnings. On the other hand, conventional options have unlimited profit potential. So, in this aspect, they are better than binary trading.
- Lack of regulation: Binary options trading is banned in several countries, particularly in many European nations like the United Kingdom. There have been many scams in this investing arena, mainly fueled by the salesy marketing promoting the simplicity of binary.
- Limited demo testing capabilities: Most binary trading brokers provide a demo platform for a few days. Of course, more time is needed to learn the ropes. It’s much better with forex brokers on MT4 where you can use a demo account for a limitless period (provided you are actively using it).
- Complex: There’s a perception that binary is easier. The concept of all-or-nothing execution is pretty straightforward, but that’s where the simplicity stops. Short-term speculation is psychologically challenging because you must make good decisions in seconds.
While long-term trading is slower, you have more time to think before you press buy or sell. It is possible to have a full-time job while trading the markets with this approach. We cannot say the same for binary, where you will need to be at your charts frequently.
It’s quite clear to see why binary options trading is globally popular. Traders can use it as their primary market or alongside other markets.
Overall, binary is best-suited for traders looking for fast-paced opportunities rather than long-term traders. But, like any market, remember there are risks involved. Also, it can take several years before reaching mastery, particularly with the exotic options.