Introduction to Binary Options

Binary options currently represent one of the quickest growing sectors in the finance industry. Although binary options have been available in the professional Currency Option Trading market for well over a decade, part of this growth stems from the fact that commodity, stock and forex binary options have become increasingly available to and popular among retail traders in the last few years.

As a result of this growing retail demand, many binary options broker websites currently offer a quick and readily accessible way of obtaining up to date pricing on a range of stock, commodity and forex binary options in relatively small dealing amounts that are accessible to retail traders.

Furthermore, using these online Option Brokerage facilities to trade binary options can significantly broaden the risk taking methods available to those individuals actively engaged in stock, commodity and currency option trading.

How Binary Options Work

Basically, binary options require a trader to pay an upfront cost or premium for the potential ability to earn a predetermined amount or payout if the binary option ends up in the money when the underlying financial market is observed at the option’s maturity date and time that is commonly known as the option’s expiration.

The phrase “in the money” or ITM simply means that the rate or strike price of the binary option is more favorable than the prevailing market in the option’s underlying instrument at the time of the option’s expiration. 

The alternative phrase is “out of the money” or OTM, and this refers to the situation where the binary option’s strike price is less favorable than the market at expiration.

Similarity to Betting

These relatively simple premium and payout characteristics of Binary Options make them similar to placing a bet on an underlying financial market with a predetermined set of outcomes.

In essence, the premium paid for a binary option represents the amount of the wager or stake that the trader gambled on their bet, while the binary option’s payout represents the winnings to be gained if the trader’s bet is ultimately successful.

This notable similarity of employing a binary option trading strategy to more traditional betting can assist novice option traders who are also gamblers in becoming more comfortable as they endeavor to learn option trading and how to employ derivatives in their trading strategies as a potential form of portfolio diversification.

Basic Components of a Binary Option Trading Strategy

The first decision to make when considering trading binary options is what underlying asset or financial market you wish to place a bet on. These assets might include forex rates, as well as commodity, stock or stock index prices.

The second decision will be to determine the amount of time until expiration of the binary option you wish to purchase.

The last decision will be the forecasted direction of the binary option based on your prediction for the underlying market’s movement during the time frame until the option’s expiration. Basically, if you think the market will rise, you will want to purchase a call, but if you think the market will fall, you will want to purchase a put.

Binary Options Terminology Explained

For those who wish to learn option trading, and how to trade binary options in particular, one of the first steps to take is to gain a thorough understanding of the highly customized terminology commonly used to refer to these various aspects of these derivatives.

To assist in this endeavor, the following list consists of frequently used words and phrases related to trading binary options that might make up part of a binary option trading guide.

Nevertheless, it is worth noting that the terms used to refer to characteristics of binary options can vary somewhat between different binary option brokerage firms, so be sure to clarify exactly what these terms mean at the binary options broker you intend to use.

Asset: Also sometimes known as the underlying, this term refers to a commodity, stock, index or currency pair upon which the binary options are based.

At the Money (ATM): The situation where the binary option’s strike price is the same as the current price of the underlying.

Binary Option: An option that pays out a fixed amount if in the money in return for a known premium that is paid up front.

Call Option: Sometimes called an “above” option, it gives the purchaser a fixed payout if the underlying market is higher than the binary option’s strike price.

Current Price: Refers to the presently prevailing value of the underlying asset that binary options are based on.

Digital Option: Another term used to refer to binary options, and especially to those binary options that have fixed odds.

Expiration: The date and time that binary options mature and when these options are determined to be in, out of, or at the money based on the value of the underlying.

In the Money (ITM): The situation where the binary option’s strike price is more favorable than the current price of the underlying.

Out of the Money (OTM): The situation where the binary option’s strike price is less favorable than the current price of the underlying.

Payout: The amount that binary options generate for the purchaser if they expire in-the- money.

Premium: The up front cost involved in purchasing binary options.

Put Option: Sometimes called a “below” option, it gives the purchaser a fixed payout if the underlying market is under the binary option’s strike price.

Straddle: A binary option trading strategy that involves purchasing both a binary put option and a binary call option with the same strike price.

Strangle: A binary option trading strategy that involves purchasing both a binary put option and a binary call option with different strike prices, usually with both strike prices set initially out of the money by a similar amount.

Strike Price: The asset price characteristic of binary options that the underlying market must exceed — in the case of a call option — or be below — in the case of a put option — in order for the binary option to generate a payout.

Underlying: This term, also sometimes called the asset or underlying asset, refers to the commodity, stock, index or currency pair that the binary options are based on.

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Binary Options Can Help Avoid Order Problems in Volatile Markets

The limited risk nature of trading binary options helps make purchasing them an especially interesting option trading strategy over very volatile trading periods.

Basically, using a long binary option trading strategy allows a trader to remain involved in a fast market without being subject to especially frustrating trading problems like substantial stop loss order slippage and briefly triggered stop loss orders after which the market subsequently reverses.

Using a binary option trading strategy in such a situation usually involves purchasing binary options that expire soon after the volatile period has concluded. Employing this sort of strategy can help a stock, commodity or forex trader manage such potentially problematic markets in a way that limits their risk to the premium paid for the binary option.

Non Farm Payrolls Binary Option Trading Strategy Example

For example, when a major economic number like U.S. Non-Farm Payrolls comes out, the forex market can go haywire for a short period of time while the news is discounted into the various major exchange rates.

These sharp price swings can result in frustrating forex trading challenges like barely triggered stop loss orders from which the market promptly recovers. Such volatility can also result in substantial slippage on stop loss orders that can be a painful surprise to a trader expecting to be filled at their order level.

A savvy trader might use a forex option trading strategy that involves purchasing a binary option straddle. This is a two legged option trading strategy in which both a binary call option and a binary put option with the same strike price are purchased on the underlying exchange rate.

Thus, if the Non-Farm Payrolls result comes out substantially different from the market consensus and the forex market reacts strongly, the trader will likely be able to profit on the leg of the binary options strategy that has gone in the money.

Furthermore, if the volatile market then reverses and returns to previous levels, as is sometimes the case, then the trader may be able to benefit from profits on the other leg of the binary option trading strategy.

Beware of Higher Premiums and Lower Payouts

It is perhaps worth mentioning that some online binary option broker websites are probably wary of writing binary options over such volatile trading periods due to the greater risk involved.

As a result, they may reduce payouts on binary options accordingly, and they might also mark up the premium cost of purchasing such riskier binary options. This effect can be even more notable with especially short term binary options with tenors that include a major risk event that is widely expected to create volatility in the underlying market.

Nevertheless, traders who have access to a decent binary option brokerage service that offers competitive pricing can usually still take advantage of the useful limited risk characteristic of binary options to help them manage risk appropriately while still being able to participate in especially fast markets.

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