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What are Binary Options?

Binary options are a relatively new form of investing in which an individual can speculate on the direction of the market, or an individual stock or even a currency. Like typical options “Binaries” involve an underlying vehicle like a stock but unlike a typical option all settlements are in cash and you can’t take delivery of the underlying vehicle.

What are Binary Options?In many ways, binary options are simpler than typical options. There are only two variables… the first is time, i.e. when does the option expire and the second is the direction the price will move. With traditional options there are three variables, time, direction and strike price (with binaries the strike price is the price at the time of purchase).

With binary options trading, you make money if the price ended in the direction you thought it would based on the starting (strike) price. If you expect the price to go up and the starting price is $10 you would buy a “Call” Binary option. Supposing it finished at $10.01 or $10.50 or $20 you would make the same amount of money. Conversely, if you had purchased a “Put” (expecting the price to go down) and it had ended at any price above $10.00 you would lose your entire investment.

With a traditional option you can be right on the direction and still lose money. In the example above the current stock price is $10.00 and you expect the price to go up. But buying an option with a $10.00 strike price (at the money) is fairly expensive so you may opt for an $11.00 strike price. When the option expires if the price is $10.99 you still lose the entire price you paid for the traditional option.  So you are speculating not only on direction but also on the distance the price will move. Also traditional options have set strike prices, you can’t get one with a strike price of $10.01 or $10.69. For lower priced stocks, usually below $25 the strikes are at .00, .25, .50 and .75. On higher priced stocks the strike prices are spaced further apart (perhaps only on the dollar) . So choosing the proper strike price is an integral part of buying a traditional option but with binary options that choice is eliminated.

Disadvantages of a Binary Option

But there is a down-side to the ease of choosing a strike price. The first drawback is that is that you only get a fixed return. In a traditional option the “more right” you are the more you get paid. For instance, assuming our option on a $10.00 stock with an $11.00 strike cost us $1.00 and the underlying asset moves to $12.00…  in a traditional option you would make $1.00 profit or 100% on your money but if it moved to $20.00 you would make $9.00 or 900% profit. Of course, a move that large would be highly unlikely.

Another major drawback of high-low binary options is that the reward is always less than the risk. In other words, it is like betting against the house in a casino, the odds are never in your favor.  This means a trader must be right a high percentage of the time to cover losses.

U.S. vs Overseas Binary Options

Binary options outside the U.S. are offered by individual brokers, not on an exchange. Much like a casino, these brokers make their money from the discrepancy in the odds between what they pay out on winning trades and what they collect from losing trades. Most foreign binary options brokers are not legally allowed to solicit business from U.S. residents unless that broker is registered with a U.S. regulatory body such as the SEC or Commodities Futures Trading Commission.

Starting in 2008, the Chicago Board Options Exchange (CBOE) began listing binary options for U.S. residents. These options are handled in a less “casino like” fashion. Rather than betting against the house these options require both a buyer and a seller and the price is based on known risk reward ratios so the prices are constantly changing. Thus in U.S. based options, it is your choice. Do you want options where the odds are in your favor or the “long shot” that will pay you big. You also get to choose whether to be a buyer or a seller.

In the U.S. Binary Options, the maximum risk and reward is known if the binary option is held to expiration, but you have the ability to sell early to another buyer based on the then current risk/reward based price. In U.S. based binary options the exchange makes their money from an exchange fee (for matching buyers and sellers) and not by stacking the odds in their favor.

See Also:

Binary Options: Fixed Odds Financial Bets Options Trading A Newbies’ Guide Trading Binary Options: Strategies and Tactics

Image courtesy of Stuart Miles / FreeDigitalPhotos.net”.

About Tim McMahon

Work by editor and author, Tim McMahon, has been featured in Bloomberg, CBS News, Wall Street Journal, Christian Science Monitor, Forbes, Washington Post, Drudge Report, The Atlantic, Business Insider, American Thinker, Lew Rockwell, Huffington Post, Rolling Stone, Oakland Press, Free Republic, Education World, Realty Trac, Reason, Coin News, and Council for Economic Education. Connect with Tim on Google+

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