Introduction to Binary Options Trading

Investing, Investing Strategy, Investments
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You know the saying: Don’t try to time the market. But binary options trading does just that. The investment strategy is frequently compared to gambling, for good reason: Investors are placing a bet on how a market or asset will move in the very near future.

What are binary options?

In trading binary options, you’re predicting whether an asset class will be above or below a certain price at a certain time. Here’s where the gambling knock comes in. If you’ve ever been to Las Vegas, it’s a little like over/under betting.

Predictions like this aren’t the best strategy for most investors. We strongly recommend a portfolio of index funds for long-term goals like retirement. But if you have some extra cash and you want to ease into options trading, binary options contracts can be a decent way to do it.

Binary options are often referred to as “yes or no” investments. If you think an asset will be above a set price, you’re predicting “yes” and buying the binary option. If you think an asset class will fall below a set price, you’re predicting “no” and selling the binary option.

There’s a low barrier to entry. A binary option contract won’t cost more than $100. You’re not buying the underlying investment or even the option to buy the underlying investment. You’re simply placing a bet on how that investment’s price will move.

These contracts always close at either $0 or $100; you either win or lose. If you predict the price movement correctly, you’re on the winning side of the trade, and the person on the other end of the contract — who predicted incorrectly — is on the losing side. Your earnings or losses can’t top $100 on a single contract, which means your exposure to risk is limited.

Limited, but far from nonexistent. You can trade multiple contracts to increase potential profits; the less fun side of that coin is that you’re also increasing potential losses.

Assets that can be traded as binary options

As with other investments, the assets available to trade as binary options will depend on the broker you choose. That’s an important note. The binary options industry is rife with scams, so if you decide this is a trading strategy for you, it’s important to trade through a company that’s regulated by the U.S. Commodity Futures Trading Commission or the National Futures Association.

That’s a small list. Major brokers typically don’t offer binary options because they’re complex and not very popular. The largest regulated binary options broker in the U.S. is Nadex.

In general, you can trade on:

  • Stock indexes, like the S&P 500, Nasdaq, Russell 2000 and FTSE 100.
  • Forex (currency pairs).
  • Commodities, like precious metals, crude oil, natural gas, soybeans and corn.
  • Individual stocks.
  • Economic events, like the federal funds rate or the jobs report.

How binary option trades work

To place a binary option trade, you’ll walk through three main steps:

  1. Decide on an asset or market to trade.
  2. Decide on an expiration date or time for the option to close. Most trading platforms let you sort by expiration date, so you can view contracts that expire within the next few hours or days. Most contracts will expire by the end of the trading week, except those tied to economic events.
  3. Decide if you want to buy or sell the binary option, based on the strike price and expiration date. The strike price is essentially a line in the sand. If you think the asset will be above the strike price when the contract expires, you buy the binary option. If you think the asset will be below the strike price, you sell the binary option.

Say you want to trade on the S&P 500, and you choose a contract with a strike price that’s slightly higher than where the market is right now. That strike price is 2,075, and the expiration is 3 p.m. Remember, in binary options trading, you’re deciding whether you think an asset will be above or below the strike price at a certain time. The question here: Will the S&P 500 be above 2,075 at 3 p.m.? If you think the answer is yes, you buy the option. If you think the answer is no, you sell the option.

Here’s where things get complicated: As with many investments, there’s a bid price and an offer price, and they can fluctuate rapidly. With binary options, the bid is used when you’re selling a contract, and the offer is used when you’re buying a contract.

The bid and offer prices are always under $100. Let’s say that in our hypothetical trade, the bid on the S&P 500 contract is $35 and the offer is $40. If you buy the binary option, you’ll pay the $40 offer price. If you sell the binary option, you’ll sell at the $35 bid price. You think the S&P 500 will be above 2,075 at 3 p.m., so you buy the binary option contract for $40. That’s the most you can lose in the trade.

  • If you bet correctly — and this is, at its heart, a bet — the binary option settles for $100. Your profit is $60, since you put the offer price of $40 down (which you also get back). You’re now “in the money” in options lingo, for obvious reasons.
  • If you’re wrong, and the S&P 500 is lower than 2,075 at 3 p.m., the trade settles for $0. You don’t get anything, and you’ve lost the $40 you put down. You are now, sadly, “out of the money.”

If instead you think the S&P 500 will be below 2,075 at 3 p.m., you’d sell the binary option.

  • If you’re correct, your profit is the bid, or the price at which you sold the option, which was $35.
  • If you’re wrong, and the S&P 500 goes higher instead, you lose $65 ($100 less the $35 bid).

You can also exit the trade early at some brokers, which will cut your losses if your prediction looks to be wrong, or lock in a profit if your prediction appears to be trending toward correct.

But wait, back up: How do you make this prediction?

Therein lies the issue. It’s hard to predict the markets. If it were easy, we’d all be swimming in $100 bills. The key here is research. You’re not making a blind prediction, at least not if you want to make money. The goal is to make what your elementary-school science teacher probably called an educated guess. To do that, you should:

  • Practice with a binary options demo account if you’re new to this trade strategy. The losses you take when you’re green won’t sting as badly if they’re paper money.
  • Understand the market you’re trading. We’d recommend picking a market to trade and sticking to it at first. If you’re into currency trading, trade forex. If you’re already following the S&P 500, trade on that.
  • Use technical analysis tools, like price charts, which will give you a historical view of how the asset you’re trading has behaved in the past and an indication of how it might behave in the future.
  • Keep track of your trades. A trading platform will keep a record of your order history, but a good accompaniment is an old-fashioned notebook. No, it’s not the most advanced trading tool. But keeping notes about your trades — what went wrong, what went right — can help guide future strategies.

As with any investment, there are pros and cons, risks and rewards here. Binary options are marketed as a relatively low-risk trading strategy, but we’d treat it like gambling: Don’t put up more than you can afford to lose.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.