Binary Option Trading Explained
Binary options trading is becoming increasingly popular all over the world and there is a lot of hype happening around it. It also leads to many people being so excited about trading that they don’t actually ask: what is binary options trading exactly?
If you are one of those traders that want to understand what it is and how it works, we are here to guide through the basics of binary options trading.
What is binary options trading?
Binary options, which is also known as digital options or fixed-return options among traders, is a special class of options. In it, the payoff is either a fixed predetermined amount or is zero.
With the standard high-low binary option, a trader would buy would a binary call option is they think that the price of underlying asset is going to go up. Consequently, they would buy binary put option is they think the price will go down. From here, the situation can have two possible outcomes: either a trader was right in his assumptions and receives a payoff or he was wrong and he loses his initial investment.
Since binary options have only fixed returns, it doesn’t really matter by how much the price of underlying asset has increased or dropped. The mere fact of increase/decrease is what’s important. The payout is fixed and is known before entering a trade. Normally it is around 70% or 80% of the amount invested.
One more thing that is important to mentions when talking about binary options trading basics is expiry time of a trade. It is customizable and ranges anywhere between 60 seconds and a few weeks. So a trader can decide himself when he finds out the outcome of each particular trade.
A Typical Binary Option Trade
So what does a typical binary options trade look like? Let’s take a look at the following chart.
So let’s imagine that a traders is tracking the price movements of it for a few hours and comes to a conclusion that the price will go up during the next 5 minutes. In fact, he is so sure of it that he decides to invest $100 in this trade. So he purchases a binary call options EUR/USD with the expiry time of 5 minutes.
And he is right! The price goes up with a small difference and is now $1.31. But the fact that it went up by only $0.01 is not what’s important. What matters is that it did and the trader receives 85% payout which in his case is $85.
If we imagine that he was wrong and the price would actually go down instead, he would lose his initial investment.
The important lesson here that it wouldn’t matter for a trader if the price went up drastically (let’s say to $2.4) or went down by much (to $1.00). He only cares about the mere fact of the price change as it will determine the outcome of this particular binary options trade for him. And this is what binary options trading is about.
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References and Further Reading:
- Simple Technical Trading Rules and the Stochastic Properties of Stock Returns (WILLIAM BROCK, JOSEF LAKONISHOK, BLAKE LeBARON)
- A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets (Harrison Hong, Jeremy C. Stein)
- Defining and Estimating a Trading Area (David L. Huff)
- Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors (Brad M. Barber, Terrance Odean)
- Trading blocs and the Americas: The natural, the unnatural, and the super-natural (Jeffrey Frankel, Ernesto Steinb, Shang-jin Wei)