FIGURE 1: APPLE, INC.
Q&A
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
BINARY OPTIONS: TO TRADE OR NOT TO TRADE?
I got a question the other day that had to do with a recent product called binary options — what they are, and if they were worth trading. Can you tell me?
A binary option, much like placing a bet, is basically an all-or-nothing option, meaning you either make a predetermined payout or asset if you are right or you get nothing if you are wrong. Binary options fall into one of two categories: all-or-nothing cash binaries, or all-or-nothing asset binaries. Each of these categories has both call and put options. So when choosing a binary option to trade, you must first ask yourself, “Do I want my payout in cash or in the asset?” From there, you determine the type of option.
Say you think that Apple, Inc. (AAPL), will close at or above $700 by the close of trading (Figure 1). You want to trade a binary option on AAPL where if the stock trades at or above $700 a share, you receive a $100 payout per contract. You decide to buy a call option on AAPL closing at or above $700 at 4:00 pm at a cost of $50 for the contract. What’s the risk and reward for this binary option trade?
FIGURE 1: APPLE, INC.
The risk involved in this trade is the amount that you purchased the binary call option for, which in this case is $50 per contract. Remember, this is an all-or-nothing trade. You can lose all the money invested, which in this case is $50. Your maximum reward is the payout itself ($100 per contract) minus the amount you bought the contract for ($50). If AAPL closes at or above $700 by today’s close, your net profit will be $100 made from the payout, minus $50, which was the amount entering the trade.
Of course, like an equity option, you could also choose to liquidate (buy or sell to close) the AAPL position prior to expiration, at which point the option value is not guaranteed to be the full amount of the payout. The farther away the price of the asset is from the strike price, the more the value of the binary option decreases, as the option is less likely to expire at the binary option strike price.
BINARY OPTIONS TRADED
Binary options have been around for a while now, but the introduction of computerized platforms from exchanges such as the American Stock Exchange helped make them popular in 2008.
Currently, there are more than 90 different firms that trade binary options. Surfing over to one of the brokers that offers binary options, I found that there are about 20 stocks offered for binary option trading, but that’s not all. Nearly every currency pair you can think of also offers binary options, and there are a handful of commodities that do as well, such as gold, crude oil, and coffee. Let’s not forget about indexes, which include US and global stock markets.
BINARY BROKERS
A quick scan online of brokers who trade binary options revealed companies I have never heard of before. Further, when checking into accounts, I found that it takes only a few lines of entry to get an account up and running.
This can be both good and bad — good because I don’t think there is a barrier to entry; anyone can open a binary option account. From the website I was looking at, you could be up and trading as fast as a few mouse-clicks. In fact, the broker I was looking into took a Visa credit card as a form of account deposit! That concerned me about what type of person trades binary options. In addition, the brokerage firm I visited had no offices in the US, meaning that they were outside of regulations.
CONCLUSION
While binary options have been around a while, it is still new to me as well as many of the readers here. If you are interested in becoming part of the binary trading world, then I suggest doing what I did. First, get knowledgeable. Learn all you can about binary options and know that they are different from the vanilla-based options that we might be used to. Second, know your risks, both in the binary option world as well as the risks you take using a binary broker. And finally, like any good-minded trader, ask questions before committing any money to this product. That’s what I do prior to investing in anything new. Good trading! —Tom