Binary options are wagers on whether a particular event will occur. Will an underlying asset—the closing value of a market index, the value of a currency, etc.—be above a certain price at a certain time? Traders place trades based on whether they believe the answer is yes or no. This makes them among the simplest financial instruments to understand, though strategies involving them are often not. This simplicity has helped them gain broad appeal among traders and newcomers to the financial markets. However, U.S. regulators have repeatedly warned traders of the dangers they involve, particularly via off-exchange platforms. They are banned across Europe, Australia, the U.K., and many other jurisdictions because of their volatility and are often seen as wagers more akin to gambling than sound investing.
“All-or-nothing investments involve a high degree of risk, and many binary options promotions online are frauds,” said Lori Schock, director of the Securities and Exchange Commission’s (SEC) Office of Investor Education and Advocacy. “Internet fraudsters may use binary options or other trendy investment buzzwords as a lure for investors when they really intend to rip you off.”
As such, traders should fully understand how binary options work, what markets and time frames they should use with them, and which companies are legally authorized for U.S. residents. We provide you with the knowledge you need below.
Key Takeaways
- Binary options are based on a yes or no proposition and have either a fixed payout or nothing at all if held until expiration.
- These options come with the possibility of capped risk or capped potential.
- Trading activity leads to changes in the bid and ask prices as the market wagers on which option is more likely.
- Regulators have warned traders about scams involving binary options, which are banned across Europe, the U.K., and Australia.
Understanding U.S. Binary Options
Binary options are an alternative when considering speculating or hedging, but only if you fully understand the two potential outcomes of these options. Both the risk and the profits are capped.
The best way to explain them is with an example. Suppose you’re considering a binary option that asks, “Will the price of gold be above $1,830 at 1:30 p.m. today?” If you think the price of gold will be above $1,830 at that time, you might buy the binary option. If you think gold will be at or below $1,830, you’ll sell this option. The price of a binary option ranges between $0 and $100, and there’s a bid and ask price as in other financial markets. The exchange tells you how much you stand to make whichever side of the trade you choose.
Let’s say the binary option is trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option, you’ll pay the offer price of $44.50, excluding fees. If you decide to sell at that moment, you’ll sell at the bid price of $42.50. Suppose you buy at $44.50. If the price of gold is above $1,830 at 1:30 p.m. when your option expires, the option becomes worth $100. Your profit is calculated as follows: $100 – $44.50 = $55.50 (minus fees). However, if gold is below $1,830 at 1:30 p.m., the option expires at $0, and you lose the $44.50 you put in, plus any fees.
It’s important to note that the bid and offer prices for the binary option go up and down until the expiration time based on market conditions and the perceived probability of the option finishing in the money. If the price moves favorably for you, the value of your binary option will increase, and vice versa. For example, let’s say you bought the binary option at $44.50, and after some time, the offer price rises to $60 due to unexpected market conditions. If you close your position early, as the platform Nadex often allows you to do, you can sell the option at $60, resulting in a profit of $60 – $44.50 = $15.50 (minus fees). By closing your position before expiry, you can lock in a profit without waiting for the option to expire.
Conversely, if the market moves against your position and the bid price drops to $30, you may sell the option at $30 to minimize your loss rather than risk the option expiring out of the money and losing your entire investment. This provides you with some flexibility.
However, you can only do this on Nadex’s exchange. The Cboe, the other exchange permitted to sell binary options, and the Chicago Mercantile Exchange (CME), which offers event futures, don’t allow you to exit your position before expiration. This means you cannot mitigate your losses once you buy your option ticket.
A Zero-Sum Game
Every binary option expires at $100 or $0: $100 if the proposition is true and $0 if false. Each thus has a total value potential of $100, and it’s a zero-sum game. When you profit, someone loses, and when you lose, someone profits.
Traders must put up capital for their side of the trade. Suppose you buy an option at $44.50. Your maximum risk is $44.50 if the option settles at $0, costing you $44.50, apart from fees. The person who sold the binary option has a maximum risk of $55.50 if the option settles at $100: $100 – $44.50 = $55.50, excluding fees.
A trader can buy many contracts on the same event. Suppose the option is a wager that the S&P 500 Index closes above 4405.2 at 4:15 p.m., and the bid and offer are $18.00 and $24.00, respectively. You would buy the binary option at $24 or lower if the index is above 4405.2 at 4:15 p.m. You sell at $18 or place an offer above that price and hope someone buys it if you think the index will be below 4405.2.
You buy at $24.00, thinking the index will rise above 4405.02, called the strike price, by 4:15 p.m. Below is an image taken from the Nadex platform to buy one such contract at $24. The app calculates your maximum loss and gain, your return on investment, and the probability of being in the money. Together, this is a ticket. The maximum profit on this ticket is $76, and the maximum loss is $24, apart from fees.
Nadex Ticket Example
Source: Nadex
How the Bid and Ask Prices Are Determined
The bid and ask prices for binary options are based on market conditions, the perceived probability of the option expiring in the money, and the time until expiry.
Market conditions: The underlying market sentiment and price movement of the asset (e.g., gold, stocks, or currencies) directly influence the bid and ask prices of the associated binary options. If the market moves in favor of the binary option’s condition (e.g., the price of gold rising above the strike price), the option’s value will increase, and vice versa.
Perceived probability: The bid and ask prices also reflect the market’s perception of the likelihood that the binary option will expire in the money. If traders believe there’s a high probability of the option finishing in the money, the bid and ask prices will be higher, closer to $100. Conversely, if the perceived probability is low, the prices will be lower, closer to $0. When traders are undecided, the price is closer to $50.
Time until expiry: As the expiry time approaches, the prices will converge toward either $0 or $100, depending on the likelihood of the option finishing in the money.
Volatility: Higher volatility in the underlying market can lead to wider spreads between the bid and ask prices, as increased uncertainty makes it riskier for market makers to offer the option.
Where To Trade Binary Options
Binary options can be traded on two regulated exchanges in the U.S.: the North American Derivatives Exchange (Nadex) and the Chicago Board Options Exchange (CBOE). In 2022, the Chicago Mercantile Exchange (CME) began offering event futures, which are very similar to binary options and usually called that in the U.K. An event futures contract has a binary outcome: It settles at $100 if the event occurs (or a specific outcome is achieved) and settles at zero if the event doesn’t happen. You can buy up to $2500 in contracts for each outcome on each exchange.
Another platform, Cantor Exchange, closed in 2019, though it provides a lesson to be wary in this part of the investing world. Three years after it closed, the company settled with the Commodity Futures Trading Commission (CFTC) over a slew of violations, from insufficient computer network safety to failing to report on 200,000 binary options trades from 2017 to its closure. That was a regulated exchange, and the SEC and CFTC have said that unregulated platforms are even more likely to be involved in fraudulent activities or scams. It’s illegal to allow Americans to trade on them. In March 2024, a U.S. District Court entered a judgment worth over $200 million in penalties against Bluemoon Investments, an illegal, off-exchange binary options firm. Bluemoon pursued trades from Americans and made extravagant promises to lure them in, all while manipulating the results to generate further profits for the company. They are not likely to be the last platform to face such penalties.
Important
“Many fraudulent exchanges are offshore and unregulated by U.S. laws, which can ultimately mean that they are beyond the reach of U.S. law enforcement,” said Schock from the SEC. “If you get scammed by one of these operators, it may be virtually impossible to get your money back.”
Nadex, a U.S.-based exchange, offers retail traders regular binary options, call spreads, and “touch-bracket” contracts. These can be traded directly without the need for a broker. Besides regular binary options, Nadex offers the following:
- Call spreads: Also known as vertical spreads, these involve simultaneously buying and selling call options with different strike prices but the same expiration date, limiting potential gains and losses.
- Touch-bracket contracts: Also called knockout options, these are like traditional binary options, though once it hits a specific number, the contract expires right away.
The Cboe offers a more limited range of binary options, primarily focusing on yes/no propositions related to the S&P 500 and CBOE Volatility indexes. These binary options are cash-settled and have European-style exercise, meaning they can only be exercised at expiration. The payout for these is a fixed amount if the option finishes in the money and nothing if it’s out of the money.
What To Consider When Buying Binary Options
Binary options are high risk, and it’s crucial to understand the potential risks and rewards before committing your funds. In this section, we’ll discuss the essential aspects to consider when purchasing binary options, including fees, time frames, and other critical elements that can impact your returns.
Fees For Binary Options
Nadex’s fees are relatively straightforward. The exchange charges a trading fee of $1 per contract per side for each trade (entry and exit). There’s no fee if a trade expires out of the money. However, if the trade is profitable and expires in the money, there is an additional $1 fee per contract. There are no fees for account setup, electronic check deposit, or withdrawal, but there are costs for wire transfers or returned checks.
The CME’s event futures range from $1 to $99 to trade. The fees depend on the broker you use and your trading volume. The Cboe’s binary options have fees that depend on which index you’re trading and several other factors.
Pick Your Binary Options Target
Nadex, CME, and Cboe offer a variety of events futures and options based on well-known indexes such as the Dow (Wall Street 30), S&P 500 (US 500), Nasdaq 100 (US TECH 100), and Russell 2000 (US Smallcap 2000). This lets you invest in the performance of some of the largest and most influential companies in the U.S. You can also wager on indexes worldwide.
Forex traders have perhaps the most diverse offerings in binary options since binary options cover the major currency pairs, including the EUR/USD, GBP/USD, USD/JPY, and EUR/JPY, as well as less traded pairs like the AUD/USD, GBP/JPY, USD/CHF, EUR/GBP, and AUD/JPY.
For those interested in commodities, binary options on price moves in crude oil, natural gas, gold, and silver are available. While these binary options are affected by news events, event futures at the CME can trade directly on the news. You can buy or sell options based on your predictions of whether the Federal Reserve will increase or decrease interest rates or on crucial economic indicators like jobless claims and nonfarm payrolls.
Pick Your Binary Option Time Frame
A trader may choose from binary options in the above asset classes that expire intraday, daily, or weekly.
Intraday options: These provide prospects for day traders, even in quiet market conditions, if they correctly choose the market’s direction.
Daily options: These expire at the end of the trading day and are useful for day traders or those who are hedging hedge stocks, forex, or commodity holdings against that day’s moves.
Weekly options: These are traded by swing traders throughout the week and day traders as the options’ expiry approaches on Friday afternoons.
Event-based contracts expire after the official news related to the event is released, so all types of traders take positions well before and right up to the expiry.
Pros and Cons of Binary Options
Like any investment, binary options have advantages and disadvantages.
Pros
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Risks are capped
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Payouts are known
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Easier to learn
Cons
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Gains are capped
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Can be volatile
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More akin to gambling than traditional investing
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All or nothing.
The main advantage of binary options is their simplicity. Unlike traditional options, they have a fixed payout and expiration, making them easy to understand for beginners. Traders know their potential profit or loss upfront, so the risk-reward ratio is clear.
Binary options also offer a variety of underlying assets whose moves are at stake, including stocks, commodities, currencies, and indexes. This diversity allows traders to choose assets they are familiar with or interested in.
However, binary options have drawbacks. The primary disadvantage is the high level of risk. The all-or-nothing nature of binary options means that a wrong prediction results in the total loss of the invested amount. This is very different from trading in stocks, where there’s still value left after a downturn, short of a total bankruptcy.
Another concern is how it educates—or fails to do so—novice traders about the market. All-or-nothing trades are more like casino games than typical investing. No underlying asset remains, and the binary nature of the outcome means there’s no potential for long-term growth or compound interest.
In traditional investing, even if a stock or asset loses value, the investor still owns a piece of that company or asset, which can regain value over time. With binary options, the outcome is final once the trade is done, and there’s no way to recover losses. This can create a dangerous mindset for new traders, who may view binary options as a quick and easy way to make money without fully grasping the risks involved.
Anyone considering binary options trading should thoroughly educate themselves on the market’s mechanics, develop a solid risk management strategy, and understand that binary options should be viewed as a speculative tool rather than a reliable, long-term investment vehicle.
Are Binary Options Safe?
The Financial Industry Regulatory Authority warns that many binary options sites found online are fraudulent. It advises sticking with U.S. options if possible.
How Does a Bid and Ask Price Work?
The bid price represents the most an investor will pay for a determined number of shares at a set time. The ask price is the flip side. It refers to the seller and identifies the least it will accept. The bid price is almost always less. The difference between the two numbers is referred to as the “spread.” The spread is considered to be indicate liquidity.
What Is Slippage in the Forex Market?
Slippage occurs when a trade is executed at a price different from what was anticipated. A downward slip occurs when the executed price is less, and an upward slip occurs when the opposite happens. Trading when market volatility is low can minimize the gap.
The Bottom Line
Binary options are based on a yes or no proposition. Your profit and loss potential is determined by your buy or sale price and whether the option expires worth $100 or $0.
Within the U.S., they are traded via the Nadex and Cboe exchanges, with event futures traded on the CME. Foreign companies soliciting U.S. residents are usually operating illegally and should be avoided. Binary options trading has a low barrier to entry, but that doesn’t mean it’s easy to make money. There’s always someone on the other side wagering you’re wrong. Only trade with capital you can afford to lose, and trade first with a demo account to become comfortable with how they work before putting any of your money on the line.
Read the original article on Investopedia.