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What are binary options?

May 17, 2020, 14:38 PM

*NOTE: Schaeffer's does not endorse the usage of binary options. This answer is purely informational as we are regularly asked about binaries by our clients*

Binary options are a type of exotic option that offers traders an all-or-nothing payoff -- you either win or lose. The basis behind any given binary options trade is whether the underlying asset will be trading above or below a specific price at a specific time, and the apparent simplicity of the marketplace -- along with the allure of quick profits -- has generated quite a bit of interest in binary options.

However, binary options trading comes with enormous risks, pitfalls, and drawbacks. And for those operating without the right expertise and guidance, the losses can add up just as quickly as the profits. In fact, promotion of the use of binary options is forbidden on major search engines like Google.

How do Binary Options Work?

As the name indicates, binary options offer traders a "yes or no" proposition on each trade. Exchange operator Nadex phrases the underlying question of each binary option as, "Will this market be above this price at this time?"

For example, if a speculator thinks that, yes, crude oil will be above $50 per barrel at that day's settlement, he could buy the corresponding binary option. Alternatively, a speculator who thinks that no, crude oil will not settle above $50 per barrel, would sell that binary option.

Binary options are priced anywhere between $0 and $100 in the U.S., and those numbers also reflect the two possible monetary outcomes for every trade. If the trader's yes/no bet was correct, the option is "in the money," and it's worth $100 at expiration. That figure, less the initial cost of entry, is the profit on the trade.

If the trader's yes/no bet was wrong, the option expires "out of the money," and is worth $0. In this scenario, the initial cost to buy the binary option is written off as a loss.

Binary Options vs. Stock Options

While the maximum profit on a winning binary options trade will always be $100 less the cost of entry, stock options allow the investor to reap profits that are up to 200% or more of the original premium paid -- a feature known as leverage. In most cases, we won't even take up an options buying position unless we expect to at least double our initial investment.

And in fact, when buying call options, the profit potential is theoretically unlimited, since there's no cap to how high the underlying share price can rise! So, right out of the gate, equity options offer far greater profit opportunities than binary options.

The outcomes on a losing trade are often preferable with equity options, too. While binary options are an "all or nothing" proposition, a trader whose stock option position is moving adversely can take steps to close out the position before it's at a total loss. And even for trades that do eventually incur the maximum 100% loss (equivalent to the initial premium paid, as with binaries), the far greater profit potential ensures that the risk/reward profile is more appealing for equity options trades in just about every possible scenario.

Finally, equity options are available to trade on a huge number of stocks and ETFs across a wide variety of exchanges and platforms, with expiration dates listed just about every week for the most popular assets, and strike prices in increments as small as a half-point. Plus, the industry and markets are highly active, liquid, and regulated. So you can fine-tune your strategy to match your forecast just about exactly, and then you can rest easy knowing that your trade will be executed and carried out smoothly

So what's a binary-curious trader to do?

If the binary extreme "all or nothing" approach ruffles your feathers, but the thought of quick profits on simple trades leaves you drooling, there is a solution.

For any trader looking to dip their toes into the profit pools of options, weekly options are… frankly, a better option.

An options trading program that focuses on trading weekly options – that is, options that expire on the Fridays outside of standard expiration -- may offer the perfect compromise for traders who wants to chase quick gains with minimal risk.

With weekly options, you can "customize" your expiration date, so you aren't paying for time premium you don't need, and you're still able to capture money-multiplying profits on short-term equity moves, limiting both your risk and market exposure.

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