The Trading Power of Binary Options

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By ValueWalk for Nadex

Bringing new investment products to the masses is always controversial, and binary options have been no different. Resistance from elite opinion makers have put some investors off before they even investigate the matter for themselves, and a few shady websites and providers have given the entire industry a black eye, but the growth of regulated, respected binary option trading providers gives traders the opportunity to enhance their investment strategy with an entirely new set of tools.

The power of yes or no

Binary options, also called digital options or yes/no contracts, are short-maturity options that pay off depending on whether the underlying financial instrument is above the agreed upon strike price at expiration or not. To make that concrete, if you buy an option saying that the S&P 500 will be up 25 points when trading closes then you get paid in full if you’re right (typically $100) and you don’t get anything if you’re wrong; whoever sold the contract (your counterparty) is in exactly the opposite position – they get $100 if the market doesn’t cross the strike price at expiration and nothing if it does.

There are two really important things to understand about this setup. First, the total risk is capped. If you buy a contract for $60, then you can’t lose another penny. Unlike the more complicated options that institutional investors usually deal with, it’s perfectly clear how much risk you’re taking on. Second, this seemingly simple financial product is a building block for more complicated investment strategies.

Turning simple tools into complex strategies

Day traders chasing intra-day returns from companies they don’t understand are gambling, but that doesn’t discredit the power of retail investment providers that let individuals manage their own portfolios. All investments carry risk, but binary options let individuals implement coherent investment strategies that weren’t feasible in the past.

As one simple example, if you think the volatility of the gold market is going to fall, you can effectively short volatility by buying one binary option with a strike price below the current gold price and selling another option with a strike price above it. If the final price falls inside the range you’ve set with the two contracts, you get paid by both, and if it falls outside that range one contract pays while the other doesn’t, resulting in a net loss. If you expect volatility to increase you can do the opposite, but this is really just the tip of the iceberg when it comes to trading binary options.

You’ve probably heard of so-called ‘exotic options’ as if they’re bizarre, opaque financial instruments designed to confound, but the truth is that all of these options are someone’s (or, more likely, some institution’s) investment strategy put into action. Binary options are intuitively clear building blocks that allow you to do the same thing on a smaller scale.

Working with a reputable (and US-regulated) provider is essential

At this point, you’re probably wondering why binary options have gotten such a bad rap. It might surprise you to hear someone working in finance say this, but the problem was a lack of regulation. Unscrupulous websites and providers promised the world to people who had never invested before, portraying binary options as a get rich quick scheme instead of the financial instrument that it is. The Securities and Exchange Commission has received complaints of identity theft, fly-by-night websites that take people’s money and then close shop, and other scams.

“We strongly encourage investors to check the background of brokers and advisers and trading platforms before making a decision to invest. If investors can’t obtain simple background information such as whether the financial professional is registered with the SEC or FINRA, then they should be extremely wary,” Director of the SEC’s Office of Investor Education and Advocacy Lori Schock wrote in an open letter to potential investors.

In the CFTC Fraud Advisory note quoted in June 2013, Nadex (North American Derivatives Exchange) was listed alongside the CME as one of three exchanges to legally list binary options in the US. The CFTC also stated that any entities outside of the three mentioned, who are offering binary options that are commodity transactions, are doing so illegally.

The SEC and CFTC have also made fraud allegations against the major binary options platform Banc De Binary, and while nothing has been resolved, this case cuts to the heart of the matter. There’s nothing wrong with binary options, but it’s essential that you trade with a legitimate provider that is registered and regulated so you know who you are dealing with. NADEX (the North American Derivatives Exchange) is the first and currently the largest CFTC-regulated exchange designed for trading binary options by retail traders in the US.

Digital options still in the early stages of growth

Some analysts still don’t think anyone without an advanced degree should choose their own stocks, so widespread acceptance will be slow, but that doesn’t mean you have to wait on the sidelines. Binary options trading isn’t for everyone, what investment is, but traders who are interested in learning more should do more research before making up their minds instead of relying on the knee-jerk reaction from analysts who know competition when they see it.

NADEX lets people set up demo accounts so they can trade with  virtual funds for a while and make a more informed decision about digital options, and if you decide to trade live, you can get started with as little as $100.00.

Futures, options and swaps trading involves risk and may not be appropriate for all investors.

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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.

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