What are binary options?

May 5, 2014 06:07 AM

Binary option contracts are simple yes/no questions that allows the end user to take a position in a particular market or on a chance of an event occurring based on his or her outlook of where that market will move in a specified timeframe.

Binaries are much simpler than futures or traditional options because every contract will settle at either zero or $100. Money management is simple because there is no leverage involved — each contract is fully margined.

It is often noted that 90% of retail futures accounts close losing money. It is hard to pinpoint the original study where that number came from but it is believable when you consider that most successful professional traders acknowledge blowing up numerous times before developing a successful approach.

Most experts agree that the double edged sword of leverage is the main reason for this poor record. To trade leveraged products successfully you need to not only be right more often than you are wrong on direction, but must have strong money management skills. Binary options take this risk off the table. At all times you know what your ultimate risk is. You will never receive a margin call with binary options.

The North American Derivatives Exchange (Nadex) is the first and largest regulated, retail focused, online binary options exchange in the United States.

Nadex offers binary option contracts on stock index, forex and commodity futures that have hourly, daily and weekly expirations.

These contracts can be used to speculate on the movement of a particular market or used to hedge an underlying position in that market for a defined dollar amount and time period. While binary options expire at either zero or $100, traders do not have to wait for expiration but could take profits or cut losses before expiration. The price is an expression of where market sentiment is at a given time.

If for instance, a contract for gold closing at or above $1,300 by the end of trading day is trading 49/51 that is an indication that the market believes there is basically a 50-50 chance of gold reaching that level. At some point in the day that will fluctuate and a trader may buy or sell the contract based on his or her belief that there is a mispricing in the market. A trader could trade that contract several times a day based on movement from his or her view of fair value.

In addition to binary options on specific markets, Nadex also offers binary options on events. There are contracts based on the Fed Funds rate, jobless claims and nonfarm payrolls. Traders can utilize these markets to express an opinion on the chance of a change in the Fed Funds rate, for example, or as a hedge if such a change would affect some other risk or position that trader holds.

Traders can use binary options to protect themselves from market spikes or to trade flat markets.

Nadex offers products with expirations from as short as two hours  to as long as a week across stock index, forex and commodity markets, all of which look to liquid futures or cash markets for their underlying values. All accounts are fully segregated.

Traders can take a position directly on the results of economic reports, such as unemployment and nonfarm payrolls, or mine those contracts for clues on sentiment in other contracts.

The great thing about binaries is risk is defined at all times. They are great tools for beginning traders but also for more sophisticated traders who can trade binaries outright or use as a hedging mechanism for an existing position.

Here we sought to introduce binaries but in future pieces will roll out the various ways to trade these unique and flexible products. 

Futures, options, and swaps trading involves risk and may not be appropriate for all investors.

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