Binary options traders use a binary option to speculate on the price movement of an asset or product, predicting whether it will rise or fall within a specified period. For a classic binary option, the outcome is binary: the trader either earns a pre-determined amount (if the prediction is correct) or loses the entire investment (if incorrect).
Key Components
The Underlying Asset
The binary option is a type of derivative. Traders choose an asset or product to speculate on, such as a stock price, an exchange rate, a commodity price, or a specific index.
Binary options make it easy to speculate on a wide range of assets and products without ever buying, owning and selling them. It should be noted however that this is not unique for the binary option; all derivatives work this way and makes it possible to gain exposure to something without owning it.
Expiration Time
Traders select an expiration time, which can range from less than a minute to many months.
Binary options with very short lifetimes are very popular, but this has also contributed to the bad reputation of the binary option as some traders use it more like gambling than investing.
Strike Price
The predetermined price level at which the trader predicts whether the asset will rise above (call) or fall below (put) by the expiration time.
Trading Process
- Choose an Asset: Select an underlying asset.
- Select Expiration: Set the lifetime of the option.
- Predict Direction: Choose whether the asset’s price will rise or fall.
- Set Investment: Decide on the amount to invest.
- Execute Trade: Place the trade and wait for the outcome.
Outcome
With a classic binary option, the outcome is binary.
- In-the-Money: The prediction is correct, and the trader receives a fixed payout.
- Out-of-the-Money: The prediction is incorrect, and the trader loses the investment.
Risks and Considerations
High Risk
Binary options trading is highly speculative and involves a significant risk of loss.
If you actually purchase a company share and the price dips, you can sell it to recouperate at least part of your investment, or you can elect to hold on to it – hoping it will rise eventually. With the binary option, you can not. It will either expire in-the-money or out-of-the-money.
Legal Risks
Many of the authorities known to be strict when it comes to consumer protection have banned brokers from offering binary options to non-professional traders.
This means that if you are a non-professinal trader and want to trade binary options, it will be difficult to find a broker regulated by any of the top-tier regulators. Going with a regulator that is not top-tier can increase the risk of ending up in the hands of a disreputable broker.
Final thoughts
Binary options trading offers a straightforward way to speculate on market movements but comes with high risk. In many jurisdictions, brokers are no longer permitted to offer binary options to non-professinal traders. If you want to engage in derivative trading, it is advisable investigate the other alternatives before you make a decision. Maybe you will find that another alternative, e.g. Contracts for Difference (CFDs), will work with your trading strategy.