Options contracts usually fall into one of two broad categories, i.e. vanilla and exotic options. Binary options are a class of exotic options in which the payoff can have only two potential outcomes and hence they derive the term “Binary”. A trader normally specifies the period and the strike price at which he wishes to exercise the options contract. The payoff is then determined by the price at which the underlying instrument is trading (market price) when the options contract expires.
If the price of the underlying product is expected to rise, it is advisable to purchase a “Call” option. The trade becomes profitable if the instrument is being traded above the strike price at its expiration, however if the instrument is trading below the strike price the trader loses his initial investment.
Likewise, if the price of the underlying instrument is expected to fall in the future, then it is advisable to purchase a “Put” option. In this case, The trade becomes profitable if the instrument is being traded below the strike price at its expiration and gives negative returns if it is trading above the strike price.
Types of Binary options:
Binary options come in different types and forms and can be customised to suit the trader’s requirements; however some of the most common forms of binary options are as follows:
High/Low options: This is one of the most common types of binary options. If the investor feels, the underlying will be above the strike price at expiration he would purchase a call option. Likewise, he would purchase a put option if he feels the underlying will fall below the strike price at expiration. The trader earns a fixed percentage of his initial investment or loses his entire investment if he guesses incorrectly.
Eg. A trader purchases a 15 day EUR/USD call option which pays him 75%, with a strike price of 1.35, for an initial investment of £100. If, after 15 days, the price of the security is above 1.35 then the trader makes a profit of £75, however if it is below 1.35 then he loses his initial investment of £100. The opposite is true if he purchases a put option.
One Touch Option: a commonly used form of binary options. Unlike the high/low option, the underlying instrument does not have to expire above or below the strike price to generate a profit. It only has to touch the strike price once during its trading duration to profit.
Eg. A trader purchases a 15 day EUR/USD one touch option which pays him 75%, with a strike price of 1.35, for an initial investment of £100. The trader earns £75 if at any time during the 15 days the underlying instrument touches 1.35, irrespective of the price at which it trades on its expiry. However, if it fails to touch 1.35 during the 15-day period, the trader loses his initial investment of £100.
Trading using Binary Options:
Despite its classification as an exotic option, it is easier to trade using binary options as compared to plain vanilla options since there can be only two possible outcomes. However, while trading binary options some of the commonly used strategies are as follows.
Early Exit: Early exit is a strategy in which the trader is allowed to exit out of a contract before its scheduled expiry. It is used to minimise losses or to profit in case the market takes a turn for the worse. The result of an early exit is that the trader receives only a percentage of his total profits or initial investment depending on whether he makes a profit or a loss.
Options Spreads: This strategy involves buying and selling an option at different strike prices to lower the initial investment outgo. The advantage of this strategy is, it lowers your losses if the strategy does not go as planned, however the disadvantage to this strategy is that it lowers or caps the profit that you can earn.
Binary options are often used in trading as a hedging tool. They are traded over-the-counter (OTC) as well as on exchanges such as CBOE and Nadex. The advantage of trading on the exchange is that it is highly regulated and monitored, the OTC markets, on the other hand, provide a greater deal of flexibility.
It should also be noted that when trading binary options a great deal of care must be taken to ensure that the risk-reward ratio does not get skewed, which can lead to recurring and significant losses. One should also seek professional guidance while trading using options.