Binary Options Versus Standard Options

Binary Options Aren’t Really Options

What defines an option and is certainly the case with standard options, which are options aside from binary options, is that they give options holders the right to exercise them and purchase or sell the underlying asset. This is why they are called options, because they are essentially an option to trade something in the future if one desires.

Whether or not we would want to do that will depend on whether it is valuable to do so, whether we can do so at a profit instead of a loss. No one would exercise an option to buy something for instance at a higher price than it is trading at the time of expiration, or to sell short something that is trading lower, because that would result in an immediate loss.

However, if we have an option to buy something at a certain price and its price has moved higher than the price we can buy it at, then we can realize an immediate gain, as we can if we are on the sell side, the put side, and the price has gone down below our strike price.

Binary options are a completely artificial version of options and do not actually involve an option to do anything with the trade, and in the majority of cases, not only can we not exercise the option, we can’t even trade it.

Once we buy a binary option, we are done, there’s nothing else to do but wait and see what happens at expiration, whether the option will be worth something or nothing.

This is a far cry from standard options and is perhaps as far away as we could get from them, given standard options can both be traded and exercised. This is just one of the differences between standard options and binary options though and the two are very distinct.

Options and Time

The biggest feature of standard options is how time affects their value. We may, for instance, buy a call option which expires in a month and we need the price to increase a certain amount in order to be in the money, at a price higher than the strike price in which the option can be exercised.

Binary Options Versus Standard OptionsLet’s say the price is $50 right now and we’re looking for it to go to $53, and two weeks into this the price is still at $50. The value of our call option will have gone down quite a bit because while we still need the price to move $3 for us to start making money, there is only 2 weeks left to go and the fact it hasn’t moved yet also affects its value since this doesn’t bode very well for the option to hit its strike price or it exceeding it by a good amount.

Each day that goes by with an options contract takes away value from it in fact, and we’re looking for it to move in our direction to first offset this time decay and then provide a level of profit.

This needing to account for time decay is what makes trading standard options so challenging. If we’re just buying the asset, we can wait as long as we need to in order to reach our profit target, $53 in this case, but with options we’re on the clock and need to do this within a certain time.

When we’re looking to trade options, with the intention of not holding it until expiration but just holding it for a briefer period of time, as traders tend to do, this is certainly trickier than just trading the security straight up. There’s not only price movement to worry about, there is time as well, in addition to other factors that influence option prices like how volatile it is and how this volatility changes, for instance with our example of the price not moving in two weeks affecting its value.

Time does also affect binary options, but not in the same way. Instead of needing to worry about changing values of the option in the trade, with binary options we only need to figure this out at the time of the trade, when we are seeking to purchase the option.

The part that is similar between binary and standard options is that there is a target and a given amount of time to reach it, so we do need to account for things like how time affects the ability for an option to hit its price, by looking at how much it needs to move and now much time it has to do so.

We then would look to calculate or get a good sense at least of whether or not this would happen, but this is done in a static fashion, just by looking at what’s going on right now. Standard options look at time and price in a dynamic way instead, with things changing moment to moment, and this certainly makes trading standard options more complicated than just the one look way that we value binary options.

When we buy a standard option, we still need to perform our analysis as to where it may be headed, the amount of time it has, the amount of volatility it has, and so on, just like we need to do with binary options. However, once we enter the trade, we need to keep doing this with standard options, re-evaluating at every turn, where with binary options we are done with the trade completely and just need to wait for the result.

This is the main reason why binary options are much simpler to trade than standard options and we could even say that they are on the complete opposite side of the spectrum, where binary options are felt to be the easiest things to trade and standard options the most difficult.

Standard Options Have Much More Profit Potential

This simplicity does come with a price, and the most obvious one is our not being able to make the big scores that are possible with standard options should we be fortunate enough to be in one of these trades.

Perhaps the biggest appeal of standard options among those looking to get into trading them is the prospect of being able to multiply your initial investment many times over if you buy an option that takes off on you. This does not happen as often as people think but when it does it does serve to excite traders.

If we are looking to do this though, standard options are really only a more complicated version of trading assets with higher leverage, and we can take advantage of moves like this the same way without having to worry about things like time decay and such by just trading things like futures, forex, or contracts for difference.

This is not to say that trading standard options is inferior, but it is more complex for sure, and does require a higher level of mastery to be able to navigate these complexities well enough to have them at least competitive with these other forms of trading. This is nowhere near where newer traders find themselves and is a lot like throwing a 6 year old kid into college without the right preparation as he or she are going to be in over their heads, and this is why we gradually move them up the grades first.

Binary options, on the other hand, have their upside capped by the payout, and if they go beyond that there is no benefit to the trader, as the payout is the maximum amount possible. This is generally somewhere between 70-90% of the price of the option, and we have to give up any further potential that a trade may have.

We might think that binary options may not be such a great deal in this case, because we’re risking losing what we paid for the option in the case of both standard and binary options, we get paid certain amounts if we hit our strike price, but binary options only pay out a certain amount, and the payoff with standard options is theoretically unlimited.

What we need to realize though is that with binary options, this 70-90% payout occurs at the strike price itself, where with standard options we’d have to move well past that point to enjoy a payout of the amount that binary options pay out. Sure, we could enjoy a bigger payout if it moves beyond these 70-90% payout levels, but we’re risking that not happening, and often it does not happen.

We don’t get the premium back with standard options, that’s our cost, and the amount that our option finishes above the strike price at expiration must first cover the cost of the premium, then return the 70-90% that a binary option would pay out, before we get to the point where the standard option would pay out more.

Therefore, while binary options do cap the upside, they guarantee a significant payout, which standard options do not. Often times a standard option will finish in the money and not pay out as much as a binary option would, because the amount it finished over its strike price isn’t high enough for this.

Binary options therefore serve to hedge things this way in addition to making all of this much simpler, with our either getting paid out this amount or not. Unless we’re skilled enough to be able to take this additional complexity into account that is involved with variable payouts, and do so well enough to add to our trading advantage, this is no advantage at all and in fact can hurt us through making the trading more difficult and have us making more mistakes.

Of the two different forms of options, there’s no question that trading standard options is considerably more difficult, although if one is skilled enough, they do have a greater potential for profit. We do need to work our way up to this though and this is not something that a newer trader should be messing with any kind of real money and we really need to put a lot of time on a simulator before we should want to venture off into real trading.

The learning curve with binary options is still there but is quite a bit less steep. We don’t want to start out thinking that it is easy to trade binary options because it is not, but it’s certainly easier than trading standard options and we can get ourselves on the right footing and moving in the right direction more quickly when we choose to start with this simpler form of options trading.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.