What are Binary Options?

Binary options have evolved to become one of the most popular financial assets to trade. Trading binary options is simply based on a ''yes'' or ''no'' proposition. The Ttrader places trades based on whether he or she believes the price of an underlying asset (stock, commodity, currency) will go up or down within a given time frame. As you might have guessed, the term ''binary'' suggests two possible trade options: you buy call options if you think the price will rise and put options if you think the price will fall. If your prediction is accurate you receive a profit and if not, you lose your money.

The simplicity of trading binary options has resulted in their broad appeal for both professional and novice traders. Another big reason behind their popularity lies in the fact that unlike trading stocks, trading binary options requires a relatively small amount of capital--most brokers require a minimum deposit of $100-$200. Each binary options broker has his profit rate, but it generally ranges from 65%-85%. There are a few brokers who allow returns of more than 100% of the capital. Some brokers also offer a loss coverage to minimize the impact of unsuccessful trades. This can be as high as 15% of the transactional amount.

Binary options vs. traditional options

Binary options vary considerably from traditional options. When trading stocks, you can receive assets at the end of the option period. However, with binary option, the assets are used merely as a reference point to predict whether the price of the asset will rise or fall. Common binary option assets include shares, indices, currencies, and commodities. 'Cash or Nothing' options allow the trader to earn a predetermined amount after a set period. On the other hand, 'Asset or Nothing' options pay out the price of a corresponding asset.

Traditional options are traded on official stock exchanges such as New York Stock Exchange. In sharp contrast, binary options are traded Over the Counter (OTC). Over the Counter trading takes place between the trader and a broker. Some digital options, however, are traded on stock exchanges, though these are the exception. The Securities and Exchange Commission (SEC) permitted Cash or Nothing trading on American stock exchanges since 2008. You can now find both European and American binary options being traded on American stock exchanges and the Chicago Board Options Exchange (CBOE).

How to trade binary options

Binary options offer you a way to trade the market with a capped risk and profit potential.

For example: will the price of gold be higher than $1,250/oz by 2.00 pm in today's trading session? If you believe the answer is yes, you buy the binary option and if you think it will below that price then you sell the binary option.

The price of a binary option is always set between $0-$100 and has a bid and an ask price. The binary illustrated above may be trading at bid price of $42.50 and an offer price of $44.50 at 1 pm. If you buy the binary option then you will pay $44.50 and if you sell you will receive $42.50. If you buy the option at 1pm and the option expires at 2pm when the price of gold is above $1,250/oz, the option becomes worth $100 and you make a profit of:

$100-$44.50 =$55.50 (less the broker's fee). This is what traders refer to as being in the money.

Conversely, if the price of gold at 2 pm is below $1,250/oz, the option expires at $0 and you lose your $44.50 investment. This is what traders refer to as being out of the money.

The bid and ask price fluctuate throughout the option period until it expires. You can therefore close your position at any time before expiry either to lock in your profit or cut your loss. You can buy as many option contracts as you wish to maximize your returns.

The bid and ask price are determined by traders themselves by assessing the probability of the proposition happening or not. The higher the probability of the outcome being true, the higher the bid and ask price and hence the lower the potential profit. The lower the probability of the outcome being true, the lower the lower the bid and ask price and hence the higher the potential profit.