Why Indices Might Be An Option For Active Traders – BinaryOptions

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A Guide to Trading Binary Options in the U.S.

Binary options are financial options that come with one of two payoff options: a fixed amount or nothing at all. That’s why they’re called binary options—because there is no other settlement possible. The premise behind a binary option is a simple yes or no proposition: Will an underlying asset be above a certain price at a certain time?

Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal among traders and newcomers to the financial markets. As simple as it may seem, traders should fully understand how binary options work, what markets and time frames they can trade with binary options, advantages, and disadvantages of these products, and which companies are legally authorized to provide binary options to U.S. residents.

Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative—but only if the trader fully understands the two potential outcomes of these exotic options.

Now that you know some of the basics, read on to find out more about binary options, how they operate, and how you can trade them in the United States.

U.S. Binary Options Explained

Binary options provide a way to trade markets with capped risk and capped profit potential, based on a yes or no proposition.

Let’s take the following question as an example: Will the price of gold be above $1,250 at 1:30 p.m. today?

If you believe it will be, you buy the binary option. If you think gold will be below $1,250 at 1:30 p.m., then you sell this binary option. The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.

The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then, you will pay $44.50. If you decide to sell right then, you’ll sell at $42.50.

Let’s assume you decide to buy at $44.50. If at 1:30 p.m. the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100—$44.50 = $55.50 (minus fees). This is called being in the money. But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This called out of the money.

The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss, compared to letting it expire out of the money.

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A Zero-Sum Game

Eventually, every option settles at $100 or $0—$100 if the binary option proposition is true and $0 if it turns out to be false. Thus, each binary option has a total value potential of $100, and it is a zero-sum game—what you make, someone else loses, and what you lose, someone else makes.

Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, and so the trade costs you $44.50. The person who sold to you has a maximum risk of $55.50 if the option settles at $100—$100 – $44.50 = $55.50.

A trader may purchase multiple contracts if desired. Here’s another example:

  • NASDAQ US Tech 100 index > $3,784 (11 a.m.).

The current bid and offer are $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80, or place a bid at a lower price and hope someone sells to you at that price. If you think the index will be below $3,784 at that time, you sell at $74.00, or place an offer above that price and hope someone buys it from you.

You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the strike price) by 11 a.m. And if you really like the trade, you can sell (or buy) multiple contracts.

Figure 1 shows a trade to sell five contracts (size) at $74.00. The Nadex platform automatically calculates your maximum loss and gain when you create an order, called a ticket.

Nadex Trade Ticket with Max Profit and Max Loss (Figure 1)

The Most Important Technical Indicators For Binary Options

Consider the following bets:

  • Pay $45 to bet that the price of gold will be above $1,250 at 1:30 p.m. today. Get $100 ($55 profit) if you win, lose $45 otherwise.
  • Receive $81 now to bet that NASDAQ US Tech 100 index will go below $2,224 at 2 p.m. today. Keep a profit of $81 if your prediction comes true. If it does not, lose $19.
  • Pay $77 to win $100 if the USD-JPY forex rate goes above 78.06 at 2 p.m. today; you lose $77 if it does not.
  • Gain $33 if you bet on the price of bitcoin will go below $379.5 at 3:00 p.m. today. If it doesn’t drop that much, lose $67.

Welcome to binary options. All or nothing, one or zero, these securities are available on Nadex and the Chicago Board Options Exchange (CBOE). Binary options allow traders to make time-bound conditional bets on predefined values of stock indices, forex, commodities, events, and even bitcoin values. Like a standard exchange-traded option, each binary option has an option premium ($45, $81, $77, and $33 in the examples above), a pre-determined strike price ($1,250, $2,244, 78.06, $379.5), and an expiry (1:30 p.m., 2 p.m., 3 p.m. today).

The differentiator is the settlement price that remains fixed at $0 or $100, depending on the option condition being fulfilled. It keeps the net profit (or loss) fixed. The option premium also remains between $0 and $100. (Related: Guide to trading binary options)

Calculating Probability

Since binary options are time-bound and condition-based, probability calculations play an important part in valuing these options. It all boils down to “What is the probability that the current gold price of $1,220 will move to $1,250 or above in the next four hours?“ The determining factors include:

  • Volatility (how much and is it sufficient to cross the threshold/strike price?),
  • The direction of the price move, and
  • Timing.

Technical indicators suitable for binary options trading should incorporate the above factors. One can take a binary option position based on spotting continued momentum or trend reversal patterns. Let’s look at some of the popular binary option technical indicators:

  • Wilder’s Directional Movement Indicators (DMI) Average Directional Index (ADX): Composed of three lines, namely ADX, DI+, and DI-, and their relative positions, this indicator aims to capture the strength of an already identified trend. Here is the table for interpreting the trends:

Position

Momentum

ADX Value > 25

ADX Value

Here is an illustration, using 3M Company (MMM) stock:

Image courtesy StockCharts.com

Depending upon the identified momentum and trend strength, an appropriate buy/sell position could be taken.

  • Pivot Point(in conjunction with support and resistance levels): Pivot point analysis helps determine trends and directions for any given timeframe. Because of the flexibility in timing, pivot points can be used for binary options, particularly for trading highly liquid major currencies. A good example (with calculation and graphs) is included in the article Using Pivot Points in Forex Trading.
  • Commodity Channel Index (CCI): The CCI calculates the current price level of a security relative to the average price during any given timeframe. The average price level is usually the moving average. Time periods can be selected as desired, allowing the trader flexibility in choosing when a binary option expires. The CCI is useful in identifying new trends and extreme conditions of overbought/oversold securities. It is very popular among day traders for short-term trading and may be used with additional indicators such as oscillators. In the below formula “price” is the asset’s current price, “MA” is the moving average of the asset’s price, and “D” is the normal deviation from that average. High values above +100 indicate the start of a strong uptrend. Values below -100 indicate the start of a strong downtrend. The CCI is computed with the formula:
  • Stochastic Oscillator: In an interview, the creator of the Stochastic Oscillator, Dr. George Lane, said “it follows the speed or the momentum of price. As a rule, the momentum changes direction before price.” This important underlying detail indicates extreme cases of overbuying and overselling, allowing reversals for bullish and bearish phases to be identified. The crossover of %K and %D values indicate trade entry signals. Although a 14-day period is standard, binary option traders can use their own desired timeframes.

%K = 1 0 0 ( C − L14 H14 − L14 ) where: C = most recent closing price L14 = low of 14 previous trading sessions H14 = highest price traded during same 14-day period \begin &\text <\%K>= 100 \left ( \frac < \text– \text > < \text– \text > \right ) \\ &\textbf \\ &\text = \text \\ &\text = \text \\ &\text = \text \\ \end ​ %K = 1 0 0 ( H14 − L14 C − L14 ​ ) where: C = most recent closing price L14 = low of 14 previous trading sessions H14 = highest price traded during same 14-day period ​

Levels above 80 indicate overbought, while those below 20 indicate oversold.

  • Bollinger Bands: Bollinger bands capture an important aspect of volatility. They identify upper and lower levels as dynamically generated bands based on recent price moves of a security.

Commonly followed values are 12 for simple moving average and two for a standard deviation for top and bottom bands.

Contraction and expansion of the bands indicate reversal signals that help traders take appropriate positions in binary options. Overbought situations are indicated if the current market price (CMP) is above the top band. While overselling is indicated when the CMP is lower than the lower band.

A challenge in binary option trading is correctly predicting the sustainability of a trend over a given period. For example, a trader may take the right position for an index, predicting it would hit 1250 at the end of a five-hour period, but the level was achieved in the first two hours. Constant monitoring is needed for the rest of the three hours if the trader plans to hold the position until expiry, or a predetermined strategy should be executed (like squaring off the position) once the level is reached.

The Bottom Line:

The technical indicators discussed above should be used for timely actions with constant monitoring. One major disadvantage with technical indicators is that the results and calculations are based on past data and can generate false signals. Traders should practice caution with detailed backtesting and thorough analysis for high-risk, high-return assets like binary options.

What are Binary Options?

Shanthi Rexaline
Contributor, Benzinga

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Derivative contracts were born because of people’s innate desire to circumvent uncertainty. A derivative contract is a contract drawn up between two parties, the price of which is derived based on an underlying asset.

Table of contents [ Hide ]

The widely-used derivatives include futures, options, swaps, and warrants. A futures contract provides for buying or selling an asset at a predetermined price at a future date, while an option contract allows the purchaser of the option the right to sell or buy a specific asset at a later date at an agreed-upon price.

Apart from the basic, plain vanilla put and call options, variants called exotic options are also available. An exotic option is a little more complex, with special features or pay-off structures intended to meet specific needs of investors.

One example of an exotic option is the binary option.

What are binary options?

Binary options, as the name implies, has two possible outcomes:

  1. The price of the underlying asset finishes either above or below the specified price at the specified time. It can be categorized as one of the simplest financial assets.
  2. Based on a “yes” or “no” proposition, it allows an individual to trade, although the risk, as well as profit potential, are capped.
Binary options basics

Evolution of binary trading options

Binary options became available for retail traders following SEC approval in 2008.

Previously, binary options trading existed but was available only to banks, institutional investors or high net-worth individuals through the over-the-counter market.

In 2007, when the subprime mortgage crisis began to rear its ugly head, the Options Clearing Corporation, or OCC, embarked upon the job of developing regulatory framework for the options market, while also proposing changes to upgrade binary options to the status of a financial asset that could trade as a standalone instrument in major exchanges.

Following SEC approval, the Chicago Board Options Exchange (CBOE) and the American Stock Exchange offered binary options to retail traders. In its early days, binary options came with a lot of restrictions such as the availability of merely call options and options on the S&P 500 Index.

Slowly and steadily, the popularity of binary options increased amid the broadening of the variety of binary options available for trading and the improvement in the trading software that now allows online and mobile app trading.

Types of binary options

  • High/low option (above/below option): This is the most popular type of binary option. An investor bets on the underlying asset going above or below the predetermined price at the time of expiration.
  • Touch option: An asset will touch the strike price at the time of expiration.
  • Range option : The asset is in a predetermined range by the time of expiration.
  • 60 seconds option: As the name suggests, the 60 seconds option expires in 60 seconds from the time of purchase. A trader in the 60 seconds option should be quick and adequately backed up by a trading software with a best-in-class charting program.

Cash-or-nothing vs. asset-or-nothing

There are two forms of options: cash-or-nothing and asset-or-nothing.

A cash-or-nothing option pays a trader a fixed amount of money or nothing at all, while an asset-or-nothing options also has a fixed payoff but the payoff is equal to the price of the asset.

Other terms

  • Underlying asset: The asset on which the binary option is based upon, or a security used in the binary options contract.
  • Call: An option contract drawn up by a trader who believes the price of the underlying asset will increase by the time the option expires.
  • Put: An option purchased by a trader who believes the price of the underlying security will drop by the time the option expires.
  • Strike price: The price of an underlying asset at the time of the purchase of the binary option, compared against the price of the asset at the time of the expiry of the option.
  • In-the-money, or ITM: An option is in-the-money if a call option’s strike price is below the market price of the underlying asset, or if the strike price of a put option is above the market price of the underlying asset.
  • Out-of-the-money, or OTM: When the strike price of a call option is above the market price of the underlying asset or when the strike price of a put option below the market price of the underlying asset, then the option is out-of-the-money.

Breadth of underlying assets

Binary options provide for trading a host of underlying assets, some of which are:

Binary options example

Assume the bid and ask price of a binary options contract for the EUR-USD currency pair at greater than $1.415 are $30 and $34, respectively. A trader who believes the pair will close above the $1.415 level at 4 p.m. ET, will buy the call option at $34.

Since the option can increase in value to $100 or drop to $0 depending on how the EUR-USD pair moves, a traders makes a profit of $66 (if the pair trades above $1.415 at the specified time) or incurs a loss of $30 (if the pair trades below) $1.415 at the specified time.

Sample binary options trade

The price of the binary option is determined by the market, based on the likelihood of the proposition implied by the contract coming true. If the odds are less, the option price will be low (say $10 or $15).

If you invest $100 in a call option in the S&P 500 Index, which is currently trading at 2,875 (strike price), with an expiration time of 30 minutes, you stand to gain $100, plus a payout (if specified in the contract) if the index is above 2,875 at the expiration time.

The expiration time can be the last traded price or the average of the bid and ask price, depending on the terms set by the broker.

However, if your binary option expires out of the money, or the index is trading below the strike price, you stand to lose your $100.

If the market price is exactly at the strike price at the time of expiration, then you preserve your investment, without any profit.

Advantages to binary options trading

  • You’ll know both the risk and reward in advance, or at the time a contract is struck
  • Binary options expire quickly and can generate substantial returns with a few quick, successful trades. Expiry period could range from 15 minutes to up to a week or two.
  • Investments could be as little as $10.
  • Binary options provide an opportunity to trade with a wide range of assets available all over the world.

Disadvantages of binary options trading

  • Since some of the binary options brokers are loosely regulated, you might face the risk of losing your money if your broker opts to hoodwink you.
  • Since binary options trading is more of a speculative activity, despite the research and analysis going into it, the outcome of the investment is not always a certainty.
  • Earnings potential is limited relative to the movement in the underlying asset. Despite whether an underlying instrument moves $1 or $100 in the desired direction, your return is limited to the price of the binary option.

Brokers that allow binary options

You’ll find that a lot of brokers allow for binary options trading. However, some of them aren’t trustworthy or fall far below the threshold for acceptable brokerages. You can read more about this in our Best Binary Options Brokers guide.

Final thoughts

Since binary options trading comes with its own set of pros and cons, you’ll have to determine if it’s the right way to go for you. After all, limited regulations and limited profit potential can render it an unattractive option. However, there’s no denying of the fact that binary options are an excellent practice ground for a beginner who wants to take the plunge.

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