Binary options offer a yes-or-no wager on a specific outcome of an event, typically over a short period such as a day. Binary options present a lot of risk in a fast-paced market that could quickly change, and traders have a few strategies if they’re wagering on binary options.
Here are some popular investing strategies for binary options and what to watch out for.
What are binary options and how do they work?
Binary options give traders two choices — a yes-or-no proposition — on a specific outcome of an event. The outcome either happens or it doesn’t, and the trader either wins or loses. A binary option occurs over a defined period of time, after which the outcome of the wager is determined and paid out. Often a binary option may expire in a day, so traders know the outcome in hours.
For example, a binary option may wager on whether the S&P 500 index closes above 5,000 by the end of the day. If it does, everyone who wagered “yes” wins, while those who said “no” lose. A binary option might pay out $100 if the “yes” side wins. A bettor may purchase this contract for, say, $40 because they think the bet will happen, while the other side of the wager thinks the event won’t happen and sells that contract for $40. If the index does close above 5,000, then the winner gets $100 and the loser pays $100 — a net $60, after figuring in the $40 received upfront. The options broker takes a piece of the action for facilitating the trade, regardless of who wins.
The returns on the specific wager fluctuate to reflect the percentage of bettors on one side of the trade or the other, the way a typical bookmaker sets payouts in some sports betting. If many traders take the “yes” side of the bet, the price of the contract rises toward $100, reducing the potential reward if they’re right. On the other hand, if the “no” side looks more likely, more bettors would sell the contract and push the price lower, lifting the potential returns if the “yes” side wins.
These fluctuations happen throughout the lifetime of the binary option, as the probability of one side or the other winning rises and falls. Binary options look similar to zero-day options, given their short lifetime and riskiness, though they differ in key ways from traditional options.
It’s also worth noting that the best brokers for options trading don’t typically offer binary options, so you may need to find a broker specialized in this area. Still, one of the top names — Interactive Brokers — does offer binary options on futures markets.
5 investing strategies for binary options
1. Trade momentum
As the old adage goes, “The trend is your friend.” A market that’s moving up or down tends to keep moving that way for a while, so this kind of trade focuses on riding the trend. With this strategy, you wager on the asset’s price moving in the direction of the trend by the end of the option’s life, hoping the trend continues to play out.
2. Scalp a profit
With a scalping strategy, a trader can enter the market and try to take advantage of a short-term move to make a profit. For example, the trader may sell after a particularly risky option has moved up a certain percentage in order to lock in a gain now rather than wait for a potentially bigger gain or a loss later on. So the trader looks to profit from relatively small price changes.
3. Play a sideways market
If you think the market will move sideways for a while, you could set up binary options that take advantage of a range-bound market. For example, if you think the market is likely to stay within a certain range, you could sell options that go in the money at a high level, and thus are less likely to occur. Meanwhile, you could buy options that go in the money at a relatively low level, and thus are more likely to occur. Selling options generates income, which you can then use to purchase options with a higher likelihood of paying off.
Other more basic “single leg” strategies may play one side or the other to take advantage of what appears to be a range-bound market.
4. Specialize in technical analysis
Technical analysis looks at past price movements to help determine where the market will move in the future, including looking at its support and resistance levels. Traders may look at the market’s moving average to determine where it may go or use other sophisticated tracking tools to read the market’s chart. For example, if the market keeps hitting a specific price and can’t seem to break through that level, it’s showing resistance and you wager accordingly. On the other hand, if it seems to bounce off a low price, then it has support at that price level.
5. Wager on volatility
Any number of events can make the market volatile, and this strategy wagers simply on volatility to increase, meaning stocks are more likely to move either higher or lower. You can wager either higher or lower, according to your expectation of the market’s movement.
Risks of binary options
Binary options are more like gambling than they are investing, even compared to traditional options such as call options and put options. So it’s important to understand the risks of binary options.
- High-risk gambling: Binary options require high-risk wagers on a short-term basis, and you’re either right and win, or you’re wrong and lose your whole bet. And if you’re selling binary options, you could lose much more money than you received from the trade.
- Limited brokers: Binary options are outlawed in many places, meaning that traders don’t have many places to trade them. Most of the world’s top brokers don’t offer them. However, it’s important to work with a reputable broker.
- Associated with fraud: Binary options may often be traded on unregulated exchange platforms outside the U.S. and other similarly regulated markets, exposing you to risk.
So binary options tend to be the province of gamblers who are willing to endure the high risks.
Bottom line
The key trading strategies for binary options offer a few ways to set up your trades, but if you’re trading over short periods of time, you’re ultimately only guessing on what happens. So it’s important to remember that binary options look a lot more like gambling than they do investing. Therefore, it’s vital to never wager more than you’re able to lose comfortably.
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