Binary Options - What Are They?



A Binary Option is best described as a the type of option where the return is seen as one of two positions, either a fixed amount of some asset or nothing at all. These are sometimes known as exotics. This position is best summarized by the position of the UK tax authorities in that they treat any gains from this sort of trading as exempt from taxation as it is classed as betting.

Binary options trading is in fact a little like horse racing, in that one needs to now who which probability will be first past the post, in order to win the bet. The positive is that, unlike with horse racing, there are set formulas and strategies which will help you in your decision making.

Binary options have components common to regular, “plain vanilla” options. These include an expiration date, a strike price, and a premium for putting on the position. It is the fixed payoff where the major difference occurs. A broad range of potential uses of binary options,exist, including simple directional play, news event trading or creating hedges. I'll cover these in future articles.

Binary options which have hourly strikes give great flexibility, and open the door for a tactical approach, particularly as a substitute for stop losses in conventional trading. Refer to the comments on breakout further on.

There are two principal options – "cash or nothing binary options" or "asset or nothing binary options". These options need some explanation:

a) a cash or nothing option pays some fixed amount cash if the option finishes "in the money", i.e. a positive outcome whilst

b) all or nothing pays the value of the underlying or supporting security. By its very nature binary is limited to two possible options.

As opposed to traditional methods where placing stops above or below the preceding day’s highs or lows, or even above or below Bollinger brands, in order to create protection, the binary option can dispense with this time frame. The trader is effectively paid at the point where the strike price is exceeded.

These options are known under alternative names depending on where you are trading. In the US, on the NYSE Amex Equities, they are know as Fixed Return Options, whereas elsewhere they may be referred to as "all or nothing options" or "digital options". The latter term is seem by some as being misleading.

Let's simplify the position with an example. Suppose one makes a purchase on stock on a deal struck at $250 with a binary pay off of $500. If at the maturity date the stock is above $250 then your trade is successful and the return will be $500. If the maturity price is below $250 you will have lost your initial stake.

Whilst binary options can be traded on the AMEX, the NADEX (North American Derivatives Exchange) and other organized exchanges, there are now a number of stand-alone companies with which you can trade binary options.

Forex Binary Options Strategies

As with all trading in Forex, strategies play an important part in how you should behave in the market. These may be you own strategies or you may decide that set formulae such as the Black-Scholes Valuation formula should be your approach.

This formula is freely available in the Internet. This type of valuation process assesses how the price of an option can be found by the use of a pre-set formula. This is a complex formula based on a number of variables, namely, initial stock price, strike price, time to maturity, dividend rate, risk free interest rate, volatility and cumulative distribution function of the normal distribution.

Of these the starting point is the initial stock point and the strike price. The strike price is defined as the fixed price at which the owner of an option can purchase (in the case of a call, or buy), or sell (in the case of a put), the underlying security or commodity.

The other constituents within this formula indicate the risk element contained in this type of trading. So many variables can make trading risky, but the experienced trader can strike one bargain which will more than negate previous losses. One bargain can be very significant. Trading Forex with a binary options equation strategy could be described as being akin to having the mathematical power to correct ten negative trades with two positive trades.

This indicates the need to exercise good risk management. There is a time tried binary equation strategy, ( named after Jean le Rond d'Alembert - and a form of Martingale), which creates a “probability advantage” for gaining consistent profit. This can be used alongside of the aforementioned Black-Scholes formula. The Jean le Rond d'Alembert strategy will allow traders to “feel” the anticipated direction of the exchange rate between major world currencies. For example, on a specific day, for EUR/USD maybe be seen as greater than 1.2200, and the trader may feel that the market will settle at a price greater than that. The trader can buy if the EUR/USD exchange rate is going to be greater than 1.2200, and sell if he or she thinks that the USD/CHF exchange rate will be less than or equal to 1.2200. You cannot eliminate the risk but you can certainly minimize it.

The Black-Scholes and d'Alembert have been used in the past by institutional investors on the exchanges, but many (if not most) binary options retail traders and system providers use charting/technical analysis for generating trade signals.

Binary Options Breakouts

Forex binary options have a niche place in the financial markets in that they fit neatly into the area of breakouts, which are best described as irregular and sudden movements that need to be traded rapidly.

If one accepts that binary options options are a sound alternative to the traditional stop loss trading, then for breakouts they are ideal.

Certain events can lead to unpredictability in the market and these are not best covered by taking a long position. A good example of this is the volatility created by the recent events in Japan following the Tsunami. The effect on the Yen significantly increased volatility for a short period and this breakout gave an opportunity which was not necessarily present under stop loss trading.

We will look at binary options Forex trading as an alternative to stop losses and for hedging in a future article.

Binary Options - Why Trade Them?

They allow you to respond to market volatility. Your reaction to market trends by using good strategies permits a short term recovery approach.

In financial markets, expected returns are almost always factored into the price of the stock. Against this, a binary options market provides a different approach. It allows for skew where the volatility factor makes for immediate yet possibly predictable movements.

As long as you maintain stable and consistent binary options strategies then you will have good risk management and this will allow you to seize opportunities when they arise. The risk can be mitigated by these strategies but never eliminated.

The prime negative factor is that unlike standard Forex trading, in binary options trading the pay-outs are fixed, and risk:reward can be much less than with standard Forex trading.

Forex example, you might decide in your "normal" Forex trading that you will never take a trade with less that 1:2 risk reward. You are risking say $100 to make $200. With shorter term binary options, you are looking for payouts of typically less than a 90% profit, meaning you need a higher win rate than with conventional trading.

This can be overcome by trading binary options on longer time frames - for example, if you believe the EURUSD will close lower than the current market price in 4 days time, the payout could be 150% of your stake.

The other advantage of using an End of Day (EOD) binary options strategy is that trades can be placed in minutes per day. Weekly binary options strategies are also possible, meaning minutes of work per week.

Binary Options - Taxes

For UK traders the benefits of the binary options market is enhanced by the taxation position. The tax authorities see binary options trading as gambling and at present under the Taxes Act is exempt from taxation on gains, with no relief on losses.

In the USA the position is materially different in that the profits from binary options are treated as capital gains/losses. You can deduct a maximum of $3,000 from your gains with the balance of any losses available for carry forward. This of course follows the American approach to gambling where all wins are treated as taxable income.

The preceding taxation position may impinge upon the approach of people in the two nations and possibly accounts for greater interest in this form of trading in the UK than America.

If you are trading in countries other than UK or USA you should acquaint yourselves with the taxation position in your country of domicile or residence.

Specifically, capital gains tax normally applies to binary options