New investing products appear more and more frequently. Some of these are good innovations, others are bad and some are bad now but may improve over time as interest grows. In this article I will cover an example of a product that fits the latter category. The product I am referring to are binary options. These are new to most individuals but marketing campaigns currently underway are working hard to create awareness amongst active traders.

[VIDEO] Binary Options

Binary options are designed to eliminate a lot of the complexity of traditional vanilla calls and puts. They are called binary options because they are typically “all or nothing” trades. If you buy a binary option you will either be paid the maximum gain or you will lose your entire investment.

Most binary options currently available are further simplified by only having one strike price. If you buy a binary call and the market closes above the strike price you will be paid the maximum gain. If the market closes below the strike price then you will be paid nothing. The reverse is true for binary put options.

Lets take a look at how this works with a simple case study.

1. You feel bullish and decide to buy a binary call option on Apple, Inc (AAPL) that is currently priced at $186 a share. The option costs $100.
2. By the close of market AAPL has expired above $186 and you are paid $166, which was the maximum payout. That represents a 66% gain within a single day – sounds pretty good right? Some binary options may provide an even larger payout.
3. If the market for AAPL had closed below $186 the option would have expired virtually worthless and you would be paid nothing. That means you have lost 100% of your investment.

Although most binary options available right now look like the example above there are some variations. For example, the binary options offered by CBOE or Nadex have multiple strike prices and expirations available that are longer than a day.

Here are a few more things to keep in mind before trying your hand at binary or “all or nothing” options trading.

Binaries are Expensive:

Binary options are some of the most expensive trading instruments available to retail traders. The bid/ask spread can be up to 40% or more of the purchase price. This means you have to be right a lot just to overcome the spread. Trading costs can be a killer and right now the cost for binary options just seems way too high.

Short Term Focus:

Most short term traders lose money. Study after study has shown that actively trading in and out of stocks or other assets leads to below market returns. There is a great deal of random and unpredictable movement in the markets over short time horizons so if the best you can hope for is 50% accuracy then you will lose overall with binary options.

Illiquid:

The large spread on binary options can be partially explained by the fact that these are still very illiquid markets. Depending on where you are trading, once you buy a binary option you may not be able to sell it. You may have no choice but to sit on it until expiration. That is not an ideal situation for any trader wishing to remain flexible as the market changes.

Overall, binary options fall into the “interesting but not ready for trading” category. Inevitably there will be traders willing to blaze a trail in these option contracts and it may be worthwhile to watch these markets develop. I think it is likely that eventually they will be priced fairly enough to make sense for aggressive traders. If you find them attractive yourself, try paper trading them for now.

Author’s note:

The example I used above was representative of how over-the-counter binary option dealers offer this kind of investment product. However, this is not the only way binary options are offered. Exchange traded versions available through Nadex and CBOE are more fairly priced, constructed differently and offer the flexibility in expiration dates and strike prices that traders need. I plan to publish a part-two in this article series to dig into those differences more thoroughly.

I have also published a response we received from Dan Cook the Senior Market Analyst at IG Markets (Nadex). I thought he had a great point of view and I agree that in general, regardless of investing product, exchange traded versions are almost always better because they are more flexible, transparent and liquid. Dan and I also both agree that we hope the market continues to mature to make these options more productive for traders.

Hi John, I appreciate your article; however, I do not believe the sites you were trading on are at all representative of binary option trading. For example, traditional binaries are traded on a $ per point basis with a minimum value of $0 and a maximum value of $100.

So for instance if I have one contract representing $1 per point the most that option can be worth is $100. The fact that the site you are referring to even allows you to buy a binary at $100 defies the nature of the instrument (btw, this is not your fault, there are some sites whose house edge makes Vegas jealous). In order to get an understanding of binaries I would stick to the CFTC and SEC regulated exchanges of NADEX and CBOE.

With regard to their expense, the spread on binaries on these exchanges is usually not that different from the underlying and it is only one sided. You are correct that it can sometimes be 40% of your purchase price, such as in the case of buying a binary option at 10 ($10) and the sell price is $6 would that equate to 40% of the purchase price. It would still only represent 4% of the overall potential option value.

Additionally, from a risk perspective, and I am only speaking about exchange traded binaries, not the circus sites, binaries offer a much better risk perspective than trading a contract in the underlying. Here is an article on utilizing binary options as an addition to a traditional trading approach.

I welcome any feedback and once again, I recommend looking at the exchange trade binaries are they are a world away from what you have described above.

Image courtesy styro.