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Binary Options are a growth part of the trading business. In this article I look at what I think is interesting about binary options and why new traders should consider trading them.
Binary options look similar to traditional bet placed with a bookmaker and brokers are marketing them at both existing traders and people who do not currently trade the financial markets. There are adverts everywhere for brokers and trading strategies promising double-digit capital growth with no experience.
What is the difference between trading Options and Binary Options
Options give you right but not the obligation to buy or sell an underlying security for a particular price. Options have an expiration date and time, after which the option no longer has any value. A call is the right to buy and a put is the right to sell. If I believed that the Dow Jones Index was going to rise in the next week I could buy a call for a price higher than the current price, expiring some time after next week. If the price rises the value of the option will increase (excluding the effect of the time decay) and I could then sell this back at the higher price.
Options are popular because they allow traders to trade on margin. It is possible to control much more of a commodity, stock or ETF using an option that it would be to buy the underlying security outright. Options also allow traders to take a position on volatility.
Binary options are similar to normal options but they offer fixed odds on a specific outcome. The most popular type of binary option is higher or lower than the current price. If you guess the price move correctly then you will win a fixed amount, if you lose then you will lose a fixed amount.
Understanding of the Odds
A question that has been debated many times is whether brokers make their money solely by taking a small percentage of each trade or are they also playing the markets and taking the opposite side of the trade? If brokers are simply taking a commission per trade it would be in their interest to have profitable traders making larger and larger trades. If brokers are taking the opposite side of the trade it would be in their interest to have more losing traders who go bust or give up and are replaced by more new traders.
The odds that a trader will be successful are difficult to calculate. It depends on many factors, such as the traders skill and market knowledge, discipline, trading strategy, and market conditions. I can enter a trade with a reward to risk of 3:1 but I have no way of knowing what the chance of my trade being a winner is. The best I can do is backtest my trading strategy and rely on the fact that it would have been profitable using historic data.
Binary options are interesting because brokers are revealing how much of an edge they think they need to make a profit. Taking the example of a higher or lower bet. A typical winning return would be 80% of the amount risked. If the broker is offering a return of 80% you would need to trade a strategy that is correct more than 55.56% of the time.
This return does not seem particularly generous when compared to a casino game such as roulette (single zero roulette wheels have a house edge of 2.7%). However, market trading is not the same as casino games. A fair roulette wheel will always return the same odds but market prices are affected by a host of fundamental factors as well as technical factors such as momentum, reversion to mean, and psychological price levels.
Binary Options and Trading Discipline
Trading discipline is key to be a successful trader. Most new traders tend to act in a way that practically guarantees that they will lose. Closing winning positions as soon as they have made a small profit and then leaving losing positions running in the hope that they will turn round. Even experienced traders are guilty of closing positions at the wrong time and not sticking to the trading plan. Emotions can quickly ruin the best laid plans.
A great advantage of binary options is that once a trade has been taken there is no opportunity for an anxious trader to meddle. There is no stop-loss that can be moved or profit target tweaked, the trade will last for a set period and then close.
Binary options are therefore a good way for new traders to develop and practice their trading skills in a relatively safe way. Once a trader can consistently make profits with binary options they can branch out to other forms of trading.
Is it possible for anyone to develop a strategy that can consistently beat the fixed odds offered in binary options?
The answer to this is yes, but the majority of binary options traders will probably lose money. A binary options trading strategy must be developed and backtested with exactly the same rigour and discipline as a normal trading strategy.
Once a trader has developed a usable trading strategy they can then continue to develop and refine the strategy using backtesting and forward testing. If you are interested in developing your own strategy you could check out my video on: How to Develop Your Own Binary Option Trading System.