Stock traders venturing into the world of stock options occasionally take a turn into the niche area of binary options. These newfangled trading products have a number of unique characteristics you need to understanding before using them.
Let’s begin with the basic definition. Binary options are based on a simple proposition: Do you think an underlying asset will be above a certain price at a certain time? You can place a trade based on whether you think the answer will be yes or no.
For example, will the price of the S&P 500 be above 2,350 at 1:30 p.m. today? If you are willing to bet it will be, then you would buy the binary option. If you think it won’t be, then you would sell the binary option.
How Binary Options Work
Unlike other stock options, the price of binary options is always between $0 and $100. Though the price may fluctuate throughout the life of the contract, at expiration every binary option will settle at either $0 or $100. If the proposition outlined in the option is false, it will be worth $0, if the proposition is true, it will be worth $100.
Be aware the current price of the binary option has a bid and an ask just like other financial vehicles. You can buy the binary option at the ask price or sell at the bid price. Or, perhaps try to split the difference to get a better fill if the price fluctuates.
Here’s an example using a lesson plan I put together a while back:
Let’s say you’re considering trading the Nasdaq US TECH 100 index > $5,150 (1:00 p.m). The bid is $24 and the ask is $28. If you believe the Nasdaq index will be above $5,150 at 1:00 p.m. today then you would want to buy the option for $28. Since the option will either rise to $100 or fall to $0 depending on if the Nasdaq settles above or below $5,150, it is easy to calculate your potential risk and reward. If the proposition ends up false, your binary option will fall to $0 causing you to incur a $28 loss. On the flip side, if the proposition ends up true, then the option will rise in value to $100, netting you a $72 profit less transaction costs.
Bear in mind the price of binary option is always in motion so you can exit the trade early – usually at a partial gain of partial loss.
The price of binary options is set by the marketplace based on the odds the proposition in question will be true. If the odds of the proposition coming to pass are really low, then the binary option will be cheap — say $10 to $15.
Buyers of the option don’t have to put up a lot of capital since it’s a low-probability bet, but they could capture a lot of profit. It’s a low-risk, high-reward play with a low probability of profit. Alternatively, traders selling this binary option aren’t receiving very much compensation (a mere $10 or $15) since there’s a high likelihood of it expiring worthless. Theirs is a high-risk, low-reward play with a high probability of profit.
The marketplace offers a variety of time frames to choose from. You can trade binary options that expire hourly, daily, or even weekly. Your selection will likely depend on if you want to be a day, swing, or position trader.
In closing, let me share a few personal observations about the binary options market.
Maybe I’ve succumbed to the “can’t teach an old dog new tricks” idiom, but I don’t see the appeal of binary options for veteran stock option traders. To my knowledge, I can’t trade them through my TD Ameritrade platform. The bid-ask spread is wider than most of the normal option products I trade, which means they’re less liquid. And I have a wide-ranging number of opportunities that cross my desk daily using normal stock options so as to beg the question, “Why bother with binary options?”
While the binary nature of these options may appeal to the greenhorns among us, I suspect those looking for greater flexibility and liquidity will eventually gravitate toward the normal options market.