How Binary Options Work

Options Trading Simplified

Quite a few traders venture off into the world of options trading with visions of a lot of money being made. Options can certainly be a lucrative way to trade provided that one is experienced and skilled enough.

The problem that the majority of traders run into when they look to learn to trade standard options is dealing with the complexities involved. It’s not that standard options present great challenges that very few can meet, but they are certainly more challenging than trading other assets.

Binary options on the other hand, take an element of options trading and all trading in fact, which is the magnitude of a given move, and greatly simplify it such that a certain target is reached or it is not.

How Binary Options WorkIf the target is reached, the trader wins a prescribed amount of money, and if the target is not reached over the time period that the binary option provides, the trader loses their stake.

While there is still the element of time involved, where we need to calculate whether a certain move will occur within the time frame of the option, the binary nature of binary options, the yes or no and nothing in between, does certainly serve to make options trading much more accessible to the less experienced due to its greater simplicity.

Make no mistake, binary options trading is not easy or simple to master, but it is easier and simpler to master than standard options, that’s for sure. We could say though that the big appeal of binary options is actually its apparent simplicity, which serves to portray this form of trading as simpler than it actually is, and attracts plenty of folks who don’t really understand that there are some real complexities involved.

The Nuts and Bolts of Binary Options Trading

When trading binary options, all we need to do is be right often enough, have the successful trades outnumber the unsuccessful ones by enough to overcome the fact that we win less than we lose on these trades.

Needing to win more than we lose is normal and to be expected as all trading involves costs, and you always need to make more money than you lose to cover trading costs. The trading costs involved with binary options are by no means that modest, but they are still reasonable enough that good traders can exceed them consistently and turn a profit.

The price we do pay though for taking the magnitude of moves out of the picture, as binary options do, is that this becomes somewhat of a handicap to skilled traders, where they are rewarded for both picking winning trades and picking bigger winners than losers.

Professional traders make their money not by picking more winners than losers, but by way of the size of their winning trades providing most if not all of the profit. This is achieved by using their trading skills to stay in winning trades longer and exit losing trades more quickly.

This is not possible with trading binary options though, and your winners are always going to be smaller than your losers, by virtue of how binary options work. However, by focusing exclusively on winning rather than losing trades, we can still obtain a trading advantage with trading binary options.

In a binary option trade, a certain target will be offered to the trader, where the trader risks the price of the option in order to seek to hit the target and win the trade. These are actual bets, but all trading is essentially betting where you make or lose money from your bet depending on the outcome of the trade.

Binary options also do not involve ownership of an asset like buying stocks do, and this does concern some people, but there is no real difference here between owning a stock and owning a position based upon it, because both derive its value from movements in price of something.

Binary options, like all options, are called derivatives, because they don’t involve ownership in anything and their value is derived from the price of something else. This is the way futures trading, forex trading, and contracts for difference trading works as well, among other things.

The fact that binary options trades are bets is just made more transparent, especially since we are dealing with a simple win or lose proposition, a yes or a no, where you lose the bet or win a certain payout.

This is exactly what happens with casino gambling, and therefore binary options may have the appearance of being similar, but this is a game of skill, not luck, like all trading is.

How Binary Options Trades Proceed

What we are looking to do with binary options is to win more than 56% of our trades, which is around the break-even point of this form of trading. That may sound pretty simple, but it does involve having a real sense of how markets move and how a particular market may move.

Binary options traders may take either side of a move, just like they can with standard options, where they can look to bet on something going up enough or going down enough, and win the trade when they are correct.

This is the simplest type of binary options trading, although there are several other variations, and it is wise for the less experienced binary options trader to start out simple. With this vanilla variation, a certain price will be specified, and the price must be at or above this point with a long trade, betting that the price will go up, or at or below a certain price if we are anticipating the price of the underlying asset to go down.

The real beauty of a trade like this, and what so many traders find so appealing, is that this is a very simple matter for anyone to understand, at least as far as what the goal of the trade is. Other forms of trading add the complexity of needing to worry about when to exit a trade, and knowing when to hold a trade and when to exit is the most difficult part of trading.

There are no such decisions with binary options, at least in the majority of cases, and although there are some which can be sold off during the trade, this is generally not an option. This is a big benefit for those who are not very experienced and skilled traders though, as there is a lot of skill involved in timing trades and if you don’t have enough of it you will be at a big disadvantage and will not be successful in fact.

Trading also involves that we monitor our trades continuously or at least periodically enough, and this is certainly the case with trading standard options as well as trading anything else out there. We must make decisions all along the way to stay in the trade and this requires a fair bit of attention.

Few people have the means or the time to do this though, and are usually working at something else during market hours. Binary options are perfect for these people, the vast majority of potential traders, because it allows us to place trades and then forget them, as we just wait until the trade concludes with no effort or attention required beyond just placing the trade.

Some brokers will allow traders to sell off their position while the trade is still on, but this is not something that binary options traders want to even consider until they become very good at timing these trades. This is the part that traders screw up the most, and this takes a lot of skill to get right.

If we can take this out of the equation, as binary options allow us to and usually require us to, this is a clear case where simpler is just better.

Binary Options Trading

The first thing to do is to open up an account with a broker that offers binary options trading, and there are plenty around. In the U.S., binary options trading is limited to just two means, through the CBOE and through Nadex, and just about all U.S. binary options traders go with Nadex due to their greater accessibility and wider range of options.

Outside the U.S., there is a plethora of binary options brokers, and while a lot of brokers are well regulated, not all are, and there are some unscrupulous operators out there that we need to steer well clear of. We always need to do our due diligence when selecting any broker, but especially with binary options brokers.

There is a wide range of things to trade binary options with, although stock indexes are the most popular and make the most sense to trade. Indexes tend to move in a more predictable manner than stocks and even commodities and therefore tend to be a wise choice, especially among those who are less experienced.

We can also buy binary options on commodities if we choose, and commodities options tend to be pretty popular as well. We can also take options on forex pairs, and this offers the ability to trade forex without putting more than your individual stake at risk, as opposed to the highly leveraged risks of cash forex trading.

Some brokers offer binary options on individual stocks, and you can even buy options on events such as the non-farm payroll report. Trying to predict fundamental forecasts like this isn’t such a great idea though, as we’re guessing for the most part here, and we need a bigger advantage to make money with binary options than guesses like this would yield.

Movements of things like stock indexes and commodity prices is at least something that allows our skills to create a trading advantage, provided that we have enough skill that is.

Binary options are offered over a wide variety of time frames, for as little as a minute to a month. Choosing your time frame is important and we want to make sure that we do have a real advantage if we’re choosing very short-term ones.

Longer term ones will limit our risk due to the lesser amount of trades but will also provide a lot less trading experience. We also need to account for how much time we have to devote to binary options trading and trading short term options won’t be something we can do unless we’re actually trading.

If we’re just doing this on the side and don’t have much time to devote to this, we can place trades that last a full day or longer and this type of trading can be used even if you just have a few minutes a day to devote to your trading.

There are a number of types of binary options trades that we may select, including whether the price will be at a certain point at expiration, whether it will hit a certain price at some point, or whether it will stay within a range. Once again, it’s best to stick to the simple price target at expiration, at least until one gets good at this.

Binary options trading has a lot of things going for it that a lot of people love, its yes or no structure, being so easy to understand, and especially, the fact that people can get started without a lot of money.

It’s therefore not surprising that this form of trading has grown so much and has brought so many people to trading that probably wouldn’t have considered it otherwise.

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.