Binary options are a type of trading option in which investors either end up making up to $100 or they make nothing. Once the investor enters into the options contract, they don’t have to do anything else.
Below, we’ll give you the full rundown about binary options, including what they are, how they work, how to trade binary options, how to make money with binary options, and finally, why it’s so important to understand their ins and outs before making any moves.
What Are Binary Options?
A traditional binary option is a type of options contract, in which investors bet whether the price of the underlying stock will be above or the option’s strike price. In industry terms, they’re either “in the money,” or “out of the money.” Prices, of course, can be hard to predict, which is what makes binary options something of a gamble.
Recommended: In-the-Money (ITM) vs Out-of-the-Money (OTM)
Here’s a fairly straightforward example: You think that the price of Stock X will be $10 or more on January 4, at 4 PM ET. You acquire a binary option contract with that stipulation — the other party on the contract holds the other position, that the price of Stock X, on the agreed upon time and day, will be less than $10.
When the clock strikes 4 pm ET on January 4, Stock X’s price is either $10, or it’s less than $10. Depending on what it is, one person is “victorious.” There’s no middle ground.
International traders may offer other variations of binary options as well.
How Binary Options Work
The inner workings of traditional binary options requires a baseline knowledge of their key elements. That includes a few things:
• The strike price. This is the price at which the option will execute, and when it comes to binary options, is the fulcrum point at which traders must choose a position — above, or below.
• The underlying asset, security, or market. This is the security (stock, commodity, etc.) upon which the options contract is based. Since options are derivatives, they’re tied to an underlying asset.
• The expiration date. The day and time when the contract executes.
• The expiration price. The price of the underlying asset when the contract executes.
These elements (along with a few other minor ones) comprise a basic binary options contract. Now, as far as how the option actually works, it’s pretty simple.
In effect, an options trader buys a binary option contract from another party who has taken the opposite position. That is, if you were to buy a contract with the position that the option’s underlying asset will exceed the strike price on the agreed expiration day and time, the other trader would have the equal and opposite position — they’re betting that the underlying asset’s value will not exceed the strike price when it expires.
When the clock does strike midnight, so to speak, on the expiration date, one of the two positions will have made the correct choice. The value of the underlying asset will either be above or below the strike price. The successful trader then receives a payout.
That payout is either $100, or nothing, regardless of how much higher or lower the value of the security is compared to the strike price. It’s like betting $100 on a World Cup match — your team either wins, in which you get your buddy’s $100, or your team loses, and you have to fork over $100.
Like all options, pricing on binary options reflects the time value of money, and their price, though always less than $100, will fluctuate depending on their current price and the length until expiration.
How Binary Options Trading Works
If you have any experience investing online, it should be pretty easy to get started. But before you do that, of course, you’ll want to make sure that you know what you’re getting into. That means doing some homework about how binary options work, the risks involved, and considering whether binary options trading jives with your overall strategy.
With all of that in mind, actually trading options contracts is almost as simple as trading stocks. You’ll want to find a binary options broker (which are usually specialized brokers such as Nadex , Pocket Option , and BinaryCent ), open and fund an account, and from there, start executing trades.
Pros and Cons of Binary Options Trading
As with any type of investment or trade, binary options have pros and cons. Here’s a quick look at them:
|Risks are capped||Rewards are capped|
|Fast and efficient||Highly speculative|
|Known payouts||Fraud Concerns|
Pros of Binary Options
There are some positives to trading binary options.
• Limited risks. Traders can only lose so much if they end with the short straw.
• Efficient process. Binary options trading is usually a fast, efficient, and easy process, and they expire quickly.
• Known payouts. Since binary options are capped at $100, you know in advance what’s at stake. It’s always nice to know where things might land, right?
Cons of Binary Options
There are also some potential disadvantages to trading binary options.
• Limited gains. There’s only so much “winning” a trader can do with a given binary options contract.
• Speculative nature. You may get the feeling that you’re simply placing a bet at the roulette table when trading binary options, so prepare for that.
• Unregulated markets. Some brokerages and exchanges that offer binary options operate outside of the United States, and away from regulators. That could increase the risk of fraud.
3 Potential Binary Options Frauds to Watch For
The risk of fraud is a bit more pronounced in the binary options sphere because many platforms and brokerages that allow traders to trade binary options are unregulated. That means they’re not conducting business under the authority of the Securities and Exchange Commission (SEC) or other regulators.
It’s worth noting that if you trade with a well-regarded broker, your chances of getting scammed are probably pretty slim. Even so, here are a few types of fraud that you may run into when trading binary options.
1. Identity Theft
You’re likely familiar with identity theft, and some traders have lodged complaints with regulators that certain online trading platforms have been collecting personal data (credit card numbers, etc.) and then using it as they will.
How might this play out in the wild? Let’s say you want to do some binary options trading, and after a bit of Googling, find a platform that looks fun and easy to use. You sign up, fork over some personal information, and start trading.
A while later, you might get alerts that your credit has been compromised, or something similar. This could be a sign of identity theft, and it may all stem back to when you gave your personal information to that trading platform.
It’ll require some investigation to get to the culprit (if it’s even possible), but the point is that some sites play fast and loose with personal information. Or, they may not do a good job of securing it.
As a rule, it’s generally a good idea to keep your personal data to yourself, and not upload it to unfamiliar platforms.
2. Trade Manipulation
You can’t win if the game is rigged, right? This is another common complaint lodged against certain brokerages. Specifically, some traders say the exchanges manipulate the software used to execute trades to ensure the trader ends up on the wrong side of the trade.
In effect, this would be a case of the dealer taking a peek at the next card in the deck during a game of Blackjack, seeing that you’re going to hit “21,” and replacing the winning card with another.
3. Refusing to Credit Accounts
Another common complaint is that some platforms accept customer deposits, but then don’t allow them to withdraw the funds. Platforms may cancel withdrawal requests, or ignore them, leaving traders unable to access their money.
If this happens and the brokerage or platform you’ve been dealing with is in a foreign country (or its location is unknown), you might be out of luck. Again, stick to well-known brokerages or platforms, and you’re less likely to run into these types of issues.
Binary Option Fees
The fees for trading differ depending on the platform or brokerage you’re using, so that’s something to keep in mind when deciding where you want to execute trades.
Some platforms make money through commissions, and as such, will incorporate fees into contract spreads. Others simply charge a per-contract fee. Check your preferred platform or brokerage’s pricing guidelines to make sure you’re comfortable with any applicable fees.
Whether you’re interested in trading binary options or stocks and bonds, it’s important to do your homework first. That means understanding a financial instrument, be it a binary option, or a vanilla stock, before you add it to your portfolio.
An options trading platform like SoFi’s can make it easier to understand what you’re getting into, thanks to its library of educational resources about options. The platform’s intuitive and approachable design allows you to trade options through the mobile app or the web platform, depending on what you prefer.
Photo credit: iStock/dinachi
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.