Binary Options

A binary option is a type of options contract where the payout is entirely based on the result of a “Yes or No?” or “True or False” question. Don’t let the name intimidate you! Although it may sound complex, binary options can be simpler to trade than traditional options or currencies.

Similar to traditional options, binary options come with a premium, a strike price, and an expiration date. The key difference is that the “premium” for the option is set by the trader (as opposed to being determined by the market in traditional options), and the expiration periods are significantly shorter. Traditional options can expire in a week to a couple of years, while binary options can expire in less than a minute to a few days.

These differences lead to the most significant distinction: how a profitable trade is calculated. Before diving into the profit aspect, let’s explore how binary option trades function.

In a binary options trade, the broker pays out a percentage of the premium at risk if the contract conditions are satisfied (for example, if the market price is at or above your target strike at expiration with a call option). Essentially, you receive a fixed profit predetermined at the outset, regardless of how much the market moves beyond the strike price or meets the contract conditions. Whether the market moves by 1 pip or 1,000 pips, the profit payout remains the same at contract expiration; there’s no middle ground. This is why binary options are often referred to as “all-or-nothing” options.

Now that we have a basic understanding of how binary option trades work, let’s consider a simple example. Suppose you decide to trade EUR/USD, believing the price will rise. The current price is 1.3000, and you think that after one hour, EUR/USD will be above that level. You check your trading platform and see that the broker offers a 79% payout on a one-hour option contract with a target strike of 1.3000. After some thought, you decide to buy a “call” (or “up”) option, risking a $100.00 premium. This is akin to going “long” on EUR/USD in the spot forex market.

Ending Scenarios After Entering a CALL Option Gain/Loss

• Expiry price is above the strike price (in-the-money): $100.00 x 79% = $79. You receive $100.00 + $79.00 = $179.00. You gain $179.00 in your account.
• Expiry price is equal to or below the strike price (out-of-the-money): You lose your stake, and your account decreases by $100.00.

As illustrated, the risk you take is limited to the premium paid for the option. You cannot lose more than your stake. This is different from spot forex trading, where losses can increase as the trade moves against you (which is why using stop-loss orders is crucial). In binary options trading, the risk is strictly limited.

Having examined the mechanics of a simple binary trade, it’s time to learn how payouts are calculated. Typically, the payout is determined by the amount of capital at risk per trade, whether you are in- or out-of-the-money when the trade closes, the type of options trade, and your broker’s commission rate.

In the previous example, you wagered $100 that EUR/USD would close above 1.3000 after an hour, with your broker offering a 79% payout rate. If your analysis was correct and your trade ends up in-the-money (ITM), you would receive a payout of $179: $100 (your initial investment) + $79 (79% of your initial capital) = $179. Simple enough, right? However, it’s important to note that there isn’t a universal formula for calculating payouts; several factors influence them.

Factors in Payout Calculations

Each broker has its own payout rate. Forex Ninja’s research indicates that most brokers offer payouts between 70% and 75% for basic option trades, while some may offer as low as 65%. Various factors contribute to determining the payout percentage, including the underlying asset traded and the time to expiration. Generally, a less volatile market and a longer expiration time result in a lower percentage payout.

Additionally, the broker’s “commission” is factored into the payout rate. Brokers provide a service for traders to execute their market ideas, so they deserve compensation. Commission rates vary widely among brokers, but with the increasing number of binary options brokers, these rates are likely to become more competitive over time.

As mentioned earlier, binary options are typically “all-or-nothing” trading instruments, meaning the payout or loss is only determined at contract expiration. However, some brokers allow you to close binary options trades before expiration. This usually depends on the type of option and is typically available within a specific timeframe (e.g., available 5 minutes after an option trade opens, up until 5 minutes before expiration).

The trade-off for this flexibility is that brokers permitting early trade closure often have lower payout rates. When trading with a binary options provider that allows early closure, the option’s value tends to fluctuate with the underlying asset’s value. For instance, with a “put” (or “down”) option, the option’s value increases as the market moves below the target (strike) price. Depending on how far it has moved past the strike, the closing value of the option may exceed the risk premium paid (but never surpass the agreed maximum payout). Conversely, if the underlying market moves higher, further out-of-the-money, the option’s value decreases, and the option buyer would receive significantly less than the premium paid if they closed early.

In both scenarios, the broker’s commission is factored into the payout of an options trade when closed early. Therefore, before diving into binary options trading, ensure you research your broker’s payout rates and conditions!

The primary factor affecting payouts is the type of binary option traded. The example provided earlier is an “up/down” option, which is the simplest type. Predicting whether a currency pair will be above or below the strike price before expiration yields the lowest return, averaging between 70%-90% depending on your broker.

More complex options, such as “touch” and “range” binary options, offer higher payouts since winning these trades is generally more challenging. Brokers typically offer payouts ranging from 200%-400%, with some even reaching as high as 750%!

Up/Down Options

An Up/Down option may also be referred to as High/Low, Above/Below, or Over/Under. It is the simplest and most common type of binary option. Traders purchase a “call” option if they believe the closing price will be above the strike price at expiration, or a “put” option if they think the market will close below the strike price. The EUR/USD trade example illustrates how an Up/Down option typically functions.

These options usually expire within an hour or a day, but some brokers offer options that expire in minutes or even seconds! This can either significantly benefit your account or lead to substantial losses, so proper risk management is essential!

Touch Options

One-Touch option trades do not require the market to be above or below a specific level at expiration; it only needs to TOUCH the strike price at least once during the option contract period to be profitable. Conversely, No-Touch trades require that the market price DOES NOT TOUCH the strike price during the contract’s life for a trader to profit.

Touch trades are available at certain times of the day, and some brokers offer them during weekends, typically providing higher payouts (around 250%-400% of your risk premium) than a simple Up/Down option trade. For example, if EUR/USD closed at 1.3100 on Friday, your broker might offer a call option that profits if EUR/USD touches 1.3450 at least once next week, and a put option that profits if the pair touches 1.2750 at least once in the same period. If you take the call option and EUR/USD reaches a high of 1.3600 during the option period, you win the trade even if it doesn’t close above the level. Conversely, those who took a No-Touch option would lose since the pair DID touch the strike price.

Touch trades tend to perform well during periods of increased volatility, while no-touch trades are ideal for pairs that typically consolidate. If that’s not thrilling enough, you can also explore Double Touch/Double No-Touch options, which function similarly to Touch/No-Touch options but require the asset’s price to touch (or not touch) two different levels for a trader to win.

Range Options

Trading Range/Boundary/Tunnel options is akin to navigating the Super Mario underwater level, where Mario must avoid touching both the top and bottom of the screen. For In Range trades, the market price must remain within a predetermined range and avoid touching the two strike prices during the option period for your trade to be in-the-money. Some brokers offer Out of Range options, allowing traders to profit if the price breaks out of the predetermined range during the option period.

For instance, if EUR/USD is trading at 1.3300 and the ECB interest rate decision is imminent, your broker might offer a range option between 1.3280 and 1.3320 that expires in one hour. If you believe the ECB’s decision will be a non-event, you could buy an “in-range” option. If the price doesn’t reach 1.3280 or 1.3320 within the option period, you win the trade. This is great news because range options typically offer the highest payouts, with some brokers providing between 200%-750%!

Range options are best utilized when volatility is low, although some brokers allow you to take a risk on the expectation that the price WILL break out of the predetermined range. Additionally, a few brokers offer options on predetermined ranges that are far from the current market price.

Remember when you enrolled in the School of Pipsology? We discussed “The Big Three” types of market analysis: Fundamental Analysis, Technical Analysis, and Sentiment Analysis. Why revisit this? Because these foundational analysis methods can also be applied to binary options trading!

Fundamental Analysis

One way to utilize fundamental analysis is through a trade-the-news strategy. If you’ve reviewed our lesson on this strategy, you know it’s best applied to events that typically cause significant volatility. The resulting spike in volatility can lead to rapid price movements, either soaring higher or plunging lower. For binary options, this is particularly effective when trading simple Up/Down options.

Essentially, you need to gauge how the price may react to better or worse than expected data and how strong that reaction might be. You just have to be confident that the price can reach the strike price of the option you purchased. For example, if you plan to trade the Australian retail sales report and have a bullish outlook on the results, a better-than-expected outcome will likely drive the Aussie to new highs, prompting you to buy a “call” option on AUD/USD. If your expectations are met and AUD/USD rises above the strike price, it’s payday!

However, consider a couple of factors when trading the news. First, assess the potential for volatility. When trading a news report and buying a binary option, you must be confident that the event will generate enough volatility for the price to reach the strike price and remain above or below that level. Trading a report that rarely causes significant movement could lead to losses.

Second, factor in the time component of binary options. For simple Up/Down options, the price must be above or below the strike price at expiration. When trading binary options with a trade-the-news strategy, you might also consider one-touch options since the price only needs to touch a specific level, not necessarily close at that level. Alternatively, you can explore Out of Range options if you anticipate strong momentum away from the previous range, allowing you to profit without needing to pick a direction.

Technical Analysis

If you enjoy using indicators like moving averages, Bollinger bands, and Stochastic, feel free to apply these tools to your trading charts when planning to trade binary options! These indicators help you assess where price action may head next and are applicable across various trading markets, not just spot currencies. Just ensure you understand how each indicator functions before incorporating it into your analysis.

Studying technical levels and inflection points can also be beneficial when trading binary options. For example, if GBP/USD has just broken down from a double top, price typically continues to decline by a distance equivalent to the height of the double top. You could consider taking a One-Touch trade if the strike price offered by your broker falls between 1.5450-1.5550, which is within the height of the double top.

Sentiment Analysis

Sentiment analysis involves gauging the market’s current “feeling” regarding broad risk flows. Are traders confident in purchasing risky assets, or are they opting to reduce risk by buying safe-haven assets or holding cash? This analysis is particularly useful for identifying trends. For instance, will EUR/USD break new highs? Or do you believe the trend is overextended and lacks momentum? Sentiment analysis can help you assess market sentiment.

If it appears that risk appetite remains high with no imminent changes to market themes, the trend may continue. If you’re confident that market sentiment will favor a risk-on environment, consider purchasing a “call” option on a risk currency or asset (e.g., Australian or New Zealand Dollar, Equities, Commodities, etc.). Conversely, if you suspect a reversal in sentiment is imminent, you might consider buying a “put” option on those same risk currencies or assets.

Combination

Just like in spot forex trading, it’s not a matter of choosing one type of analysis over another, as they can be used in conjunction. You can combine all these analysis types to form the basis of your trades. Fundamentals can provide a directional bias, while technical analysis helps assess the likelihood of the market reaching, breaking, and finding support/resistance at specific prices. Meanwhile, sentiment analysis can indicate whether the market is in a risk-on or risk-off mood.

Ultimately, the key is to learn from your mistakes and gain experience. Over time, this process will help you refine your analysis and develop sound trading practices.

Binary options trading is relatively new, gaining regulatory attention only recently as many brokers, both established and new, began offering it. Unlike spot forex trading, which is overseen by the CFTC, NFA, or other foreign regulatory agencies, there are currently few regulators monitoring binary options trading.

However, as binary options gain popularity, efforts are underway to establish regulations for this emerging trading method. The Cyprus Securities and Exchange Commission (CySEC) was the first regulatory body to recognize binary options trading as a financial instrument back in May 2012. In the U.S., Banc de Binary, a leading binary options broker, sought regulation from the CFTC for its operations, and other brokers are expected to follow suit.

Globally, other regulatory agencies are also beginning to scrutinize binary options trading. The Japanese Financial Services Authority is drafting regulations for Japan, the largest market for this product. In Malta, the Maltese Financial Services Authority (MFSA) is preparing to regulate binary options brokers in the country. As part of this process, brokers will undergo an application procedure and a strict due diligence process to obtain their operating license.

Potential application requirements may include that binary options brokers fall under the Investment Services Category 3 license and meet a minimum capital requirement of €730,000. If you plan to open a binary options account, ensure you do so with a regulated broker. Regulated brokers are typically held to higher operating standards, and if you encounter issues (e.g., trade execution, fund withdrawals), you have a higher authority to assist you in resolving those problems with the broker.

While unregulated brokers shouldn’t automatically be deemed fraudulent, trading with them can pose risks, such as a lack of guarantees that the firm’s operating funds are kept separate from client funds. Additionally, there may be no recourse if you experience issues.

Binary options trading has existed over-the-counter for some time but has seen significant growth in recent years. Currently, around 90 companies (including those who white label their products) offer some form of binary options trading service. So, why should you consider getting involved in it? Why learn a new trading method when you’re already studying spot forex? Isn’t it better to stick with what you know?

There are numerous advantages and disadvantages to both binary options and spot forex. Here are a few to help you determine which trading instrument may suit your style.

Max Risk

One of the benefits of binary options trading is that you always know the exact maximum gain or loss in advance. The trader controls the premium at risk when entering the binary options trade, and that is the only amount that can be lost. Most binary options trading service providers even allow you to minimize your maximum loss by “folding” your trades before expiration after certain conditions have been met.

In contrast, with spot forex, even with a stop-loss order in place, you cannot be 100% certain that you will only lose the pre-calculated amount you risked. While unlikely, certain issues could affect your final maximum risk, such as slippage, lack of liquidity to execute a stop order at the desired price, or a broker’s trading platform malfunctioning.

Trade Management Flexibility and Maximizing Reward

Aside from High/Low options, many binary option trades are only available at specific times of the day or week, and strike prices are often set by the broker. Even if you have an idea of how a market might behave within a certain timeframe, you may not have the best option available to execute your strategy.

In spot forex, you can enter limit orders at any price or execute a market order at any time during open market hours. Regarding exiting open trades, some binary options brokers allow you to close options trades early, but usually only after a predetermined time has passed since the option trade opened and before it closes. As mentioned earlier, the value returned to the trader is based on whether the market is in-the-money or out-of-the-money, with a portion going to the broker.

In spot forex, you can close your trade at any time (except on weekends with most brokers). Even if it’s just one second into the trade, you can exit and secure profits or minimize losses. If you anticipate a long trend and want to maximize your profit by holding the position as long as possible, you can do so in the spot market using scaling in and trailing stop techniques. In contrast, binary options have a fixed expiration date and profit cap, limiting your ability to stay in the trade.

Depending on your risk tolerance and management preferences, either trading instrument can be advantageous or disadvantageous based on how much time you want to spend in front of your trading platform, how active you wish to be, or your market expectations.

Transaction Costs

In binary options trading, there are no additional transaction costs beyond what is typically factored into the final payout. In spot forex, transaction costs come in the form of a spread, a commission, or both. We’ve discussed this in a previous chapter, but feel free to revisit that lesson for more details.

Trade Choices

Another advantage of binary options trading is that you aren’t limited to just currency pairs, as is often the case with most retail forex brokers. While currency pairs are the most common assets traded, some binary options brokers also allow you to trade individual stocks, stock indices, and even commodities.

Volatility Risk

Unexpected volatility is generally not a concern in binary options trading. Any trade you take can withstand the volatility caused by specific events. As long as your view is correct, you don’t need to worry about the market’s immediate reactions. The maximum risk is set, as is the maximum reward.

In spot forex, however, sharp price swings can significantly impact a position’s value, making it crucial to establish proper risk management processes.

Trader Error

The margin for error when entering a trade is minimal in binary options trading. This is because there are only two actions to take: open and close. There are no limit orders to monitor or adjust. In spot forex, a distracted trader may forget to place exit and/or adjustment orders, potentially resulting in a loss greater than intended.

Following a surge of aggressive marketing of binary options by primarily unlicensed brokers targeting novice traders in the mid-2010s, which led to numerous scams where traders were unable to withdraw their funds from various brokers, many countries and regions have banned binary options, including the EU, UK, and Australia.