What is binary option trading?
The definition of binary options is quite simple. They are a financial instrument that trade uses to purchase a claim on the price trends of an underlying asset. It is quite similar to vanilla options. They both represent an agreement between two parties on a security. With binary options, the two parties that enter an agreement are the binary broker and the binary trader.
The return on your trade is based on predetermined percent and depends if the option expires in the money or out of the money. If you anticipate the price trend of the underlying asset will go up you purchase a CALL option. If you anticipate it will go down, you purchase a PUT option. If the movement of the price is correct within a set time, your option is said to “expire in the money”. If the price of the asset does not move as you anticipate, your option will “expire out of the money”.
The ease of this trade underpins its success. You are more or less answering a yes or no question. Will the underlying asset price trend up or down in a specific amount of time?
How do I trade binary options?
Let’s take a simplified look at how a binary trade works:
For example, you’ve just analyzed the market information on specific asset – oil – and based on your understanding of the market, you anticipate the price of a barrel of oil will be above $49 within a given time frame, you should purchase a CALL option. If you think it will be below $49, you purchase a PUT option.
If we take this example one step further, we can say you decide to purchase that CALL option according to your analyses that the price will rise within a given time frame. When the allotted time expires, and the price of oil is $50, your option expired in the money!
The Binary Options Ins and Outs
As with any instrument in the financial market, you should never make a trade with your money unless you know that the broker and the instrument are regulated – binary options is not any different, which is a positive thing. At the end of the day regulations are around for the following reasons:
- to maintain consumer confidence
- ensure stability of the financial markets
- protect consumers,
- and limit financial crime.
Of course the focus on each of the above elements varies from financial jurisdiction to financial jurisdiction. Most countries have their own regulatory authority which oversees local financial markets. For example, the US has the Securities and Exchange Commission (SEC) as well as the Commodities Future Trading Commission (CFTC). Canada, however, doesn’t have a federal regulatory body. Each province in Canada has provincial regulatory authority. That’s why it is important to be familiar with the regulation that oversees markets and securities.
Many of the major binary brokers are regulated by CySEC – Cyprus Securities and Exchange Commission – the regulatory authority of Cyprus, an EU member state.
The regulatory system in the US is still waffling on the approach it wishes to take with binary options. The concept of binary options is in an incipient stage in the US market – in the rest of the world the industry is much more established. Both American regulatory bodies, the SEC and the CFTC, don’t regulate binary options. Part of the reason is that there are elements of binary options that would fall under SEC’s purview and elements that would fall under the CFTC’s.
Two highly successful trading strategies are “The Bandit Strategy” and “The Big Ben Strategy”. The bandit strategy works well when looking to move ahead of the market when it displays great volatility. The bandit strategy analyzes the current price against past price tends of an asset using bollinger bands. Bollinger bands make clear the standard deviations of an asset’s price based on a moving average (usually 20 day moving average). When the price of the asset approaches the 3rd standard deviation, you can really take advantage of the volatility. However, this scenario happens on limited occasions.
The big ben strategy is wonderful if you are interested in trading the currency pair GBP/USD. This is a very simply strategy. All you need to do is look at a naked chart and add resistance or support lines. When the price of the currency pair break the line on a downward or upward trend, purchase the relevant CALL or PUT option.
What tools can help me trade?
The basic tool for trading any financial security is a chart. A financial chart displays all the financial data in a visual way that allows you to make a quick and accurate assessment of what’s happening. The best thing about using a chart is that as your knowledge of trading advances you can add more and more complex indicators. However, a naked chart – a chart devoid of all indicators – is great for beginners. It allows you to mark support and resistance lines, add bollinger bands and even more complex signals.
The higher the risk, the higher the reward.
As with anything, including traditional financial instruments, the potential profits are higher if you are willing to take more risk. Binary option platforms offer a range of financial instruments from lower risk/lower reward to higher risk/higher reward.
Classic binary options uses a Above/Below (CALL/PUT) option. We discussed this option in the above example of trading on the price of oil. If you want something with minimal risk, this option is a good choice. If your trade expires in the money, you can anticipate a return of around 80%. More exotic options with a better yield also exist. With One Touch options, for example, a trader can earn 100s of percent return on a trade. But don’t forget, the risk is much higher as well.
Different binary brokers offer various financial instruments with different risk/reward ratios. The wisest approach is to review your trading strategy and how much risk you can stomach in pursuit of the highest reward.
Written by Jack Knorler