Binary options are another tactic to trade forex, as well as other commodities and securities. Although they cost relatively more than the leveraged spot forex trading offered by more and more brokers, the major advantage of binary options is the fact that the maximum potential loss is limited and specified in advance. While leveraged forex trades offer potentially higher profits because of the leveraged capital, the losses are also multiplied significantly and unknown at the time the order is called.
What are binary options?
Binary options have a binary outcome, that is, when the option expires, they either settle at a pre-determined payout value (generally $100) or $0. For the buyer of a binary option contract, the cost of the option is the bid price at which the option is trading. For the seller of the contract, the cost is the difference between 100 and the option price. The buyer receives his payout from the seller if the asset is trading at or above a predetermined value at a predetermined time. If the asset is trading below that value, the buyer loses the amount they paid for the contract, which goes to the seller.
From the buyer’s point of view, the price of a binary option can be considered as the probability of the success of the trade. So, as high the binary option price gets, the perceived probability of the asset price rises above the strike. From the seller’s view, the probability is 100 minus the option price. All binary option contracts collateralize completely, which means that the buyer and seller have to decide the capital for their side of the trade. For example, if a binary options contract is trading at 45, the buyer pays $45, and the seller pays $55 ($100 – $45). This is the maximum risk of both sides, and equals $100 in all cases.
How are binary options traded?
There are a number of assets and securities in the US that are available for trading using binary options. A binary option’s value is derived from an underlying security or asset. The purchaser of the binary option contract does not own the underlying security, nor have claim to it. Yet, the binary option’s worth is based on the movements of the underlying security price. Binary options offer an alternative way to trade these underlying securities that include stock and volatility indexes, forex currency pairs, and commodities.
Binary options are traded through the Nadex exchange and the Chicago Board Options Exchange (CBOE). Nadex provides the majority of binary options trades in the country; its binary options are traded through its own self-maintained trading platform, and an external broker isn’t needed. The CBOE offers two binary options products:binary options contracts are limited to the S&P 500 and Volatility Index. Clients need a standard brokerage account with options trading capabilities to trade these products through the CBOE. Online binary options trading sites do exist, but must be used with caution; many of these sites operate illegally and are not regulated by the SEC or CFTC, and fraud among such unregulated sites is not unheard of.