Binary Options and Their Unique Characteristics

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Binary Options and Their Unique Characteristics

The word binary means two. A binary option contract is a simple derivative contract with only two possible outcomes.

Depending on the prevailing price of the asset at expiry, the trader either loses his entire investment or receives a pre-determined profit percentage.

Thus, binary option contracts are also referred to as fixed return options (FRO) or all-or-nothing contracts.

The value of a vanilla or regular option traded on an exchange keeps changing in accordance with the changes in the price of the underlying asset.

On the other hand, the value of a binary option contract is determined only at the time of expiry. It can be understood by a simple example provided below:

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Let us assume that a buyer purchases a call option contract for gold. Let the price of gold at the time of purchasing the contract is $1200 per ounce.

Let us assume that the expiry time is one day.

At expiry, if the price is above $1200, then the binary call option contract will result in a profit. The holder of the binary contract will receive up to 92% (depending on the broker) of the invested amount. If the price is below $1200, then the binary call option contract will expire worthless. The holder of the contract will lose his entire investment. The inverse is true in the case of put option contract.

As it can be understood, there is no way to exit (some brokers offer such a facility, which we can discuss in later topics) in between.

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In the case of vanilla options, which are traded on an exchange, the value keeps changing and a trader can exit any time in between. However, the difference between the price of the underlying asset at the time of entry and exit determines the value of a vanilla option and the corresponding profit or loss. On the other hand, a binary option holder will receive the pre-determined payout even if the price has moved only a few notches favourably in the direction of trade.

The following are the most important differences between vanilla and binary options contract:

Counter parties: The binary options contract is an Over-The-Counter (OTC) product. It is not traded in any exchange (apart from Nadex which offers a totally different structure). The contracts are offered by brokers who act as the sellers (writers). The retail trader will be the buyer (holder) of the contract. In the case of vanilla options, the exchange facilitates or provides a platform for two parties to buy (holder) and sell (writer) an option contract. As it can be understood, the broker (market maker as they are called technically) bears the risk by writing the contract in the case of binary options. In the case of vanilla options, the exchange simply supervises the trade and does not bear any price movement related risks.

Expiry: The binary option contracts are created by the brokers without the involvement of the regulatory bodies. Thus, binary option brokers offer a wide range of expiry periods starting from 30seconds. On the other hand, the structure of a vanilla option contract is determined by the exchange and regulatory bodies. Thus, generally, the vanilla contracts only have monthly expiries. Being an OTC market, the binary brokers are at full liberty to customize products to suit the demand of individual traders. It is not so in the case of vanilla options contract.

Range of options contract: The binary brokers not only offer contracts with multiple expiry periods, but also modifications in the settlement process. For example, in the case of a one touch option contract, as long as the price touches a specific level any time before the expiry of the contract, the trader will receive a fixed amount as profits. However, the vanilla option contracts follow the same standard structure.

Payout: As long as the price keeps moving in the direction of trade, the value of a vanilla option contract will increase. Thus, theoretically, the profits can be unlimited. However, sudden reversals before the expiry time will erode most of the gains. In the case of binary options contract, the trader will receive a fixed profit irrespective of the quantum of price movement in the direction of trade. For example, if a binary options trader has bought a put option contract for gold at $1200, then as long as the price trades below $1200 at expiry, the trader will bag the entire amount allotted as profit. Irrespective of whether the price trades at $1199.99 or $1100, the trader would receive the same fixed percentage guaranteed at the time of entering the contract. In the case of vanilla options, practically, the trader would only incur a loss if the price trades at $1199.99. The reason is that value of vanilla option contracts suffer from time decay. Binary option contracts do not face such an issue.

Other charges: Binary option brokers do not charge any other fees for executing a trade. On the other hand, vanilla option trades would involve exchange related fees and other taxes imposed by the state where the exchange is located. The binary options broker, being a counter party (writer) to all the trades, receives the entire investment of a trader as profit whenever an option holder loses the trade. Thus, the binary options broker does not levy extra charges for executing a trade. Reputed binary options broker mitigates risk through hedging and sophisticated algorithms. This protects them from losing a large amount of money when a trader wins consistently.

Exercise time and rights: The binary option contracts are purely speculative contracts. Thus, the buyer (holder) of the contract will not have any rights to exercise (no demand can be made to buy or sell the underlying asset at the price mentioned in the contract). The contract simply ends in a profit or loss at expiry. The market maker or broker bears the entire risk. On the other hand, vanilla options traded through an exchange offer exercising rights to a trader. The trader can claim his right to buy or sell the underlying asset at or before the expiry.

Different Kinds Of Binary Option Contracts

Responding to the increase in popularity of binary options trading, brokers introduced a wide range of contracts to meet the needs and aspirations of traders.

The most popular binary option contracts are as follows:

1. High / low (Above / below or up / down):

Binary option brokers usually offer high or low contracts with short-term expiry periods ranging from 30 sec to one hour or more. As the name indicates a high contract should be bought if a trader anticipates a rise in the price of the asset. Similarly a low contract should be purchased if a trader believes that the price of an asset is going to decline.

To trade a high / low contract, a trader should begin with the selection of the asset, which can be an equity, commodity, index or currency pair. It is followed by the selection of the expiry time. Finally, the trader should decide the investment amount, which can be from $1 to $500 (minimum and maximum amount depends on the broker).

At expiry, a trader is said to have won (contract is said to be in-the-money) the high trade, if the traded price of the underlying asset is higher than the price (strike) which prevailed at the time of entering the trade. Similarly, at expiry, a trader is said to have won the low trade, if the traded price of the underlying asset is lower than the price (strike) which prevailed at the time of entering the trade.

Above / below or up / down contracts can be traded in a similar manner.

2. One touch binary options:

For every asset, at any given time, a binary broker would normally offer two one touch binary option contracts. One of them would have a target level above the prevailing price, while the other one would have a target price below the prevailing price. The trader should choose the suitable contract based on the trend forecast.

If a trader believes that the price would go up, then the one touch option contract with target price above the prevailing price should be bought. Similarly, if a trader anticipates a decline in the price of an asset, then the one touch option contract with a target price below the prevailing price should be bought. As long as the price violates the target level at least once, the trade would result in profit (option contract would end in-the-money).

If the price fails to violate the target level, then the trader would lose his entire investment. The payout can be anywhere between 70% and 550%, depending on how far the target level is. It should be remembered that even if the price crosses the target level and retraces back, the trader would be still credited with the pre-determined amount. The price need not stay above or below a particular level at expiry, as in the case of a high / low contract. A one touch binary options contract can be bought even during the weekends. A one touch options contract should be bought only when a trader expects sharp price moves in a single direction. For example, ECB, the Fed and BoJ interest rate cuts can be successfully capitalized by trading one touch option contracts.

3. Double one touch binary options:

In this contract, instead of a single target price, a broker would offer two target levels, one above and one below the prevailing price. As long as the price of the underlying asset breaches either one of the levels within the expiry time, the trade would result in a profit. If the price does not violate either of the target levels before expiry, then the trader would lose his investment. A double one touch option contract should be selected
only when a trader anticipates a rise in the implied volatility, but unsure about the direction of price movement. For example, the contract is best suited to trade news (GDP, trade balance, etc.,) announcements. The payout would be slightly less than the one touch options contract.

We shall discuss the rest of the varieties of binary option contracts in the next chapter.

Binary Options Markets

The binary options market has evolved greatly since its early beginnings. The market used to be an Over-the-Counter (OTC) instrument that was traded exclusively by high net-worth investors and financial institutions. This was until 2007 when the Securities and Exchange Commission approved proposals to open the market up to the public.

Since then, there has been a transformation in the depth of the market and in how the financial assets are traded. The binary options markets now incorporate trading in almost every financial instrument on the market today.

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Forex

We have the currency market, popularly called the forex market. Here traders can trade binary bets on the popularly traded currencies in the market. In the last one year, there have been some changes in the forex market, with three interventions in the Japanese Yen by the Bank of Japan. In addition, the Swiss National Bank (SNB) also fixed a minimum exchange rate for the Euro vs. the Confederacio Helvetica Franc (EURCHF) at 1.2000. With statements by both central banks to defend the integrity of the exchange rates of their currencies at all costs, binary bet market brokers have yanked off the Yen crosses and the currency pairs carrying the Swiss Franc from their forex market assets.

Commodities

Virtually every kind of commodity such as corn, coffee, cocoa, soyabeans, natural gas, crude oil and cotton are traded as binary options. The binary bet markets featuring commodities is a fantastic way of playing the commodities market without being unnecessarily exposed to the high-risk and volatile nature of the commodities market. Ordinarily, commodity trading requires a large capital outlay, hefty margin requirements and is extremely volatile. Not many traders can play this market successfully. But the binary bets market provides a low-cost and low-risk way of trading commodities.

Spot Metals

Though sometimes listed under commodities, I usually like to take spot metals differently as they have their own unique trading characteristics. Gold and silver are the popularly traded spot metals. Once again, the binary bet markets offers a low-risk and low-cost way of trading spot gold and silver.

Stock Index Futures

Stock index futures are a great way to play the stock markets. Many traders have lost a lot of money in stocks between 2008 and 2020. Rather than trade individual stocks, why not trade the stock index futures on the binary options markets? Virtually all the major stock indexes can be traded in the binary bets markets. This also offers traders a low-cost way of trading the index futures. Examples of index futures traded are the Dow Jones, Nasdaq, Xetra DAX, IBEX, FTSE100 and Nikkei 225.

Bonds

Many people may not know it, but bonds can also be traded on the binary bets market. You can actually trade individual bonds on the market. One example is the German government bond, which is traded on one of the popular binary options brokerages. The yields of government bonds tend to rise when the economy of the parent country is in trouble, so the news could actually give a trader some hints as to how to play them on the binary bets markets.

Stocks

Blue-chip stocks such as those of Verizon, Apple, Microsoft, Vodafone, Telefonica and British Petroleum (BP) are examples of individual stocks that can be traded as binary options.

The binary bet markets is indeed a huge opportunity that has presented itself for the taking. Perceptive traders can step out of the comfort zone of conventional investment vehicles to take advantage of what the binary bet markets has to offer. Innovations such as the development of the mobile trading platforms have also made it possible to trade binaries on the go. With the uncertainties pervading other markets, the binary bet markets look set to get increased relevance in the financial markets for some time to come.

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