A comparison of binary options (aka all or nothing/fixed return/digital options) vs. traditional spot market instruments and standard options for forex, stocks, indexes, and commodities
The following Part 1 contains chapters 1 and 2
Make 70% in under an hour! Limited risk! Just forecast the trend & rake in the dough! No experience necessary!
Try to research binary options, and that’s most of what you’ll find. The material I found was from option brokers themselves or those promoting them, and was more focused on marketing than on providing an objective look at binary options, when and for whom they may be appropriate. Full Disclosure – I provide analysis for anyoption.com.
Like most rational adults, I gave up believing in get rich quick schemes shortly after I abandoned belief in Santa Claus and that Mom was still a virgin.
Despite the dubious claims, binary options have many legitimate applications as a complement or substitute to traditional spot market instruments. The industry is growing fast for the same reason anything becomes popular, it meets a legitimate
When first learning about binary options (BOs), I couldn’t find any decent objective review of binary options’ advantages and disadvantages that made clear when and for whom they are appropriate. The following is the product of my own research and analysis to answer that need. I believe you’ll find it very helpful and objective despite my affiliation with the industry.
I’d be very grateful if any reader can recommend other good sources of information on binary options that make a good faith effort to educate rather than sell.CHAPTER 1 INTRODUCTION
Used for years by large institutions and their clients in the over the counter market (OTC), binary options (aka Digital/Fixed Return/All-Or-Nothing Options) debuted on the Chicago Board Of Options Exchange in July 2008, and have been available to online individual traders from a growing number of brokers only over the past few years. This partially explains the lack of good objective material on them.
In the following article we’ll:
- Provide basic background information for those who need it
- Examine the truth behind typical binary option broker claims
- Describe and analyze binary options’ advantages and disadvantages in greater detail
- Consider when, and for whom, they may or may not be appropriate
Here’s a brief overview of options in general and the key differences between standard and binary options. Those already familiar with them can skip to the next section.Options Basics Reviewed
An option is a right but not an obligation to buy or sell an asset at a fixed price for a fixed period. There are 2 kinds of options.CALL OPTIONS
A call option is right but not an obligation to buy an asset at a fixed price (called the strike price) during a fixed period, the end of which is called the “expiration date.” When the price of the asset is higher than the strike price, the call option is “in the money (NYSEARCA:ITM).” The more the option is in the money, the higher the price of the call option. If the underlying asset’s price is lower than the strike price, the option is “out of the money (OTM).” Depending on how much time is left before expiration, an OTM call option may still has some value and can be sold for only a partial loss. If the OTM call option is held until the time of expiration, it is worth nothing. Traders buy call options to profit from a rise in price.PUT OPTIONS
A put option right but not an obligation to sell an asset at a fixed price (called the strike price) during a fixed period that ends on the expiration date. When the price of the asset is lower than the strike price, the put option is “in the money(ITM).” The more the option is in the money, the higher the price of the put option. If the underlying asset’s price is higher than the strike price, the option is “out of the money (OTM).” Depending on how much time is left before expiration, an OTM put option may still have some value and can be sold for only a partial loss. If the OTM put option is held until the time of expiration, it is worth nothing. Traders buy put options to profit from a drop in price.
For more on options basics there’s a wealth of free material online. Just use search terms like:
Options AND introduction
Options AND beginners
Options AND “guide to”
Etc.Binary Options Vs. Standard Options And Traditional Spot Market Instruments
As its name implies, a binary option (BO) is a type of option for which there are only 2 possible outcomes, a fixed gain if the option expires “in the money”, or a fixed loss if the option expires “out of the money.”
Here are the main differences between standard, options and binary options.VARIABLE VS. FIXED TIME FRAME
Exit Standard Options At Any Time: Unlike other spot market instruments, options have a fixed maximum life the ends on the expiration date. However with a standard option you can close your position at any time prior to the expiration of the option to take profits or cut losses.
Exit Binary Options Only At Expiration: With most binary options you typically can’t exit before expiration, though this is changing. At least one broker anyoption.com, traders allow this with certain assets under certain circumstances. There may well be others that also offer the option of an early exit.VARIABLE VS. FIXED RETURNS
As their name implies:
With standard options: gains or losses can vary with how much the price of the underlying asset has moved by the time you close your position. Thus monitoring and planning your exit to maximize profits or cut losses is just as important as planning your entry point. You need to consider a variety of factors like support and resistance, momentum indicators, news and other new fundamental data, in order to decide how far you’ll let the price move for or against you before taking profits or cutting losses.
With binary options: gains and losses are fixed, regardless of how much the option is ITM or OTM. If the binary option is ITM, your profit is typically about 70% (depending on the specific asset and broker), no matter how small the movement in the underlying asset’s price. If price went against you as of the close of the position, your loss is typically around 85%, again regardless of how much the asset was OTM.THESE DIFFERENCES CREATE ADVANTAGES AND DISADVANTAGES OF BINARY OPTIONS
We’ll discuss these in depth in chapters 3-5. Here’s the short answer.
Standard spot market instruments and plain vanilla options offer more flexibility, and thus potentially greater profits and/or lower risks, at a cost of greater complexity. Only a small group of elite traders manage to master that complexity and succeed.
Specifically, in addition to correctly forecasting price movements over a given period (no small feat by itself) spot market trading demands considerable skill and discipline need for:
- Planning when to get in and when to get out: understanding how to set entry and exit points in order to keep losses from losing trades far lower than gains from winning trades
- Risk and money management: In addition to understanding how to identify low risk entry and exit points, understanding how much cash to risk on any given trade, how to identify and stop losing streaks, keep emotions out of trading, etc.
- Executing the above 2 processes. That demands firm discipline and the ability to stick to one’s plans and rules and keep emotions out of trading even when money is at stake. Easier said than done.
The entire trading process involves about 10 steps, (more if you include keeping a proper journal of your trades and studying it to learn from your mistakes) which we discuss and illustrate in Chapters 3-4, each of which requires education and practice to execute successfully.
Most traders lose both their capital and confidence within a few years, before they’ve had enough education and experience. Be it due to lack of skill, patience, or will, they don’t survive long enough to master these 10 steps.
In contrast, binary options’ fixed payout and time frame reduces the trading decision process to 3 steps (again excluding the keeping of a trading journal), allowing traders to focus on forecasting the trend during the life of the option. That simplicity makes it easier to succeed. That simplicity is critical for both new traders or those who struggle to be profitable with standard spot market trading.
Trend forecasting isn’t always simple, but is quite achievable, especially if one is selective in choosing both
- Which trends to trade
- Entry points
Both of these require solid skills in technical and fundamental analysis. Getting these is a matter of some study and practice. This process can be a matter of weeks or months rather than years, at least if one learns to identify and stick to relatively simple trading situations that only require basic analytical skills.
This simplified trading process allows traders to focus on developing their ability to identify strong trends when they exist, forecast price movements, and avoid most of the exit planning, risk, and money management issues which, if mishandled, can wipe out traders’ capital and confidence before they’ve had the time needed to develop.
Thus traders who are either new or still struggling to be profitable should strongly consider trading via binary options as a more rewarding way to ease into trading. While selections for individual stocks are limited, most major indexes, forex pairs, and commodities are available around the clock at the better binary options brokers.
The elite traders (we’re not talking about longer term investors) who are consistently profitable each year with spot market instruments and standard options will probably want to stick to what’s working for them and probably will prefer the added flexibility and potentially better reward/risk that they are skilled and disciplined enough to exploit with what their accustomed to trading.
While these stars should be hesitant to deviate from what works for them, they should consider that :
- Traders who are already successful at the more complex instruments may get even better returns with the simpler trading of binary options.
- Binary options were first used exclusively by the top tier institutional and high net worth traders, because even they needed binary options. Why? Binary options can be a potent tool to complement their usual trading. The simpler, shorter decision making process allows even the top traders to establish positions much faster, with more clearly defined risk.
That ability to trade faster can be critical when prices are moving fast and opportunities vanish quickly. That simplicity may also lead to better risk management for these stars, because it’s easy to hedge a primary position with a binary option. Thus even when traders are too fatigued or preoccupied to hedge a position via their usual instruments, they can quickly hedge and cut risk with binary options.CHAPTER 2: A LOOK AT COMMON BINARY OPTION BROKER CLAIMS
The typical claims include:
- High Returns 70% profits in as little as 1 hour.
- Much simpler, just need to predict the right direction of the trend during the life of the option
- Lower, more controlled risk.
- No spreads or commissions.
- No experience required
Let’s examine each in detail.Potential High Returns Of 70% Profits In As Little As 1 Hour
True, at least for winning trades, the ones when you correctly forecast the trend over the life of the option and it closes higher than the strike price, i.e. in the money (ITM). Actually, if that happens, it’s possible to make these returns in far less time than an hour.
Most binary option brokers offer options that expire on the hour (1:00, 2:00, 3:00 etc), and allow traders to buy puts (used to short the asset) or calls (used to go long the asset) up until a ‘lockout period that can be anywhere from 15-5 minutes before the hour and the option, expires. Thus in theory one could make 70% in 15 minutes or less, depending on when the lockout period begins.HOWEVER, NOTE THERE IS NEGATIVE REWARD/RISK
While the exact figures vary between brokers and asset classes, with losing trades cost you more than you earn from winning trades. Typically you gain 70% on winners, and lose anywhere from 100-85% on losing trades. If you do the math (see chapter 3 below), assuming 70% gains on winning trades vs.85% losses, you need to be right 55% of the time just to break even. As we discuss in depth in chapter 3, the greater simplicity of binary options trading makes high win rates quite achievable if one trades intelligently according to the guidelines we discuss in chapters 3-6.HOWEVER, SHOULD YOU TRADE BINARY OPTIONS WITH HOURLY EXPIRATIONS?
The bigger issue is, should most traders even be trying to trade such short term time frames? The short answer: only in specific cases.
Seriously now, apply the smell test.
Doesn’t 70% return in an hour or less sound too good to be true? How many of the best hedge fund managers can claim 70% a year?
In all my years of advising clients, I’ve found that such short term intraday traders tend to be either very skilled, experienced, and informed about the short term money flows that dominate intraday price movements, or very much the opposite.
As with any kind of day trading, most fall into the latter category, and would be more likely to survive with both their capital and confidence intact by trading on longer time frames in which there is more meaningful evidence available and more time to do thorough analysis of the trend.
In other words, less skilled traders will lack the information and time needed to make successful decisions. Specifically:
- The shorter the time frame, the more price movements are determined by short term money flows. Few who aren’t market makers themselves have the resources and skills to monitor and interpret those properly.
- Thus technical indicators are of more limited value over such short time frames, and trends are less reliable compared to those that form over many days or weeks.
- Fundamentals (except for breaking news stories) have almost no discernable impact during a given hour or day
They cost no more than the short term ones, and pack key added bonuses:
- Time value: The price of a standard option is based mostly on 2 factors
- Intrinsic Value: How far in or out of the money it is. The more the option is in the money, the more intrinsic value. For example if the price of ABC stock is $10, and option to buy it at $8 has an intrinsic value of $2.
- Time Value: Typically, the more time that is available, the more costly the option. Granted, even for monthly binary options, the time value is not nearly as high compared to the 3-9 months typical of plain vanilla options.
This is a key component to valuing standard options, which decline rapidly in value as they approach expiration. A $100 binary option costs the same whether it’s for an hour or a month, so obviously you’re getting some extra time value as a free bonus with longer term options
- Easier to forecast trends:
- As noted above, there is more evidence available to forecast long term trends, and more time to make informed decisions
- As detailed in the following section, success in binary options trading is mostly about correctly forecasting the trend, and longer term options allow enough time to ride the longer term, more stable trends, even if they fluctuate over the course of a week or month.
- Technical indicators are more reliable in longer time frames, and clearly positive or negative fundamental evidence and events may have enough time to influence price. Unpredictable short term money flows from large institutions can be decisive over the course of an hour or day, but the more publicly available, more easily discerned fundamental and technical factors dominate multi-day/week price movements.
- The most potent and easily understood long term fundamental forces, like changes in growth rates, interest rates, or inflation can take weeks or months to influence the price of a given asset
In sum, the odds are more on your side, because you’ve got more information, better information, and more time to analyze it.
Given the above, it should be clear that in general, beginners or less successful traders should first gain experience with the longer time frames before attempting to trade daily or hourly binary options. Once you’re already good at forecasting the longer term trends, then it makes sense to attempt the less predictable shorter term trends.
While the profits come more slowly, they are more likely to come. Besides, would you really be disappointed with 70% a week or a month, or even a fraction of that net of your losing trades?
As the industry mature, we’d hope to see longer term expirations offered beyond the current 1 month maximum that is available only from a few binary options brokers.WHEN HOURLY OR DAILY BINARY OPTIONS MAKE SENSE
There are of course, exceptions, times when an argument can be made for such short term trading:
- Trading A Bounce Off Of Established Trading Ranges: If price is in a trading range established over days, weeks, or longer, and price bounces off of support or resistance and heads back towards the middle of the range, hourly or daily options can be useful for exploiting these short term but possibly reliable trends. See Chapter 4, the section on Overcoming This Disadvantage of Shorter Term Expirations: When Daily And Hourly Expirations Make Sense, for details.
- These trading ranges can form during periods in which there is no significant news and markets are drifting as they wait for the next big event that changes sentiment for better or worse.
- The longer the channel or range has had time to form (especially if over multiple weeks) the better the odds of a winning trade if you can enter just as price bounces off strong support or resistance and you’re satisfied that the balance of technical and fundamental evidence suggests a good chance of a higher close.
- Very sophisticated, experienced traders that can track money flows and have a proven track record in trading off of 1-5 minute charts
- Last minute hedges against a primary position around the time of a major news release that can make short term price movements too unpredictable to face without some kind of hedge. The cost of this insurance means sacrificing profits, but with such a high risk off loss, that’s a legitimate choice to make.
- An attempt to play a short term news- related move, for those with some kind of track record with this kind of trading, even if only on demo accounts
- A small gamble for the fun of it. Hey, life isn’t always about profits.
In sum, unless you know precisely when to apply them, hourly or daily binary option trading risks becoming low yield gambling rather than high probability trading driven by carefully calculated risk taking.SO WHY DOES EVERY BINARY OPTION BROKER OFFER HOURLY EXPIRATIONS?
Like their spot market counterparts, brokers make money based on trading volume.
For the brokers, such fast turnover is obviously great. So, all offer binary options that expire on the hour, and most offer options that expire at the end of each trading day. Most offer nothing longer than that.
Last I checked, only anyoption.com and eztrader.com offer weekly binary options (expire at the end of Friday trading) and only anyoption.com and globaloption.com offer monthly expirations (close at the end of the final trading day of the month.
The rest offer at daily expirations or less, some offer only hourly expirations or less.
Again, few traders are likely to succeed with such short expirations except for the situations noted above.Much Simpler Than Traditional Spot Market Trading
True. As detailed in Chapter 3 below, a successful spot market trade involves about 10 separate decisions, each of which requires plenty of study and practice to do successfully. In contrast, binary option trading is comprised of only 3 relatively simple steps.
Why? The fixed time frame and payout eliminates most of the complex and often emotionally draining exit planning, and risk and money management decisions. Mistakes in these areas can and do cause potentially successful traders to lose their trading capital and give up before they’ve had a chance to develop. With binary options you only need to:
- Forecast the trend: Hardly simple but quiet achievable with study and practice, especially if you
- apply a small number of the right indicators to the more stable and predictable trends that appear on the weekly and monthly charts, and
- trade them via weekly and monthly binary options that last long enough to exploit these trends
- are very selective about choosing only the safest trends and entry points
Once you’re proficient at trend forecasting over a given time frame, the following steps aren’t even needed. However they are easy to do, and lower your risk and thus boost your income, so follow them and maximize your returns.
- Plan your entry – carefully: Just as you would with any kind of trading, try to get in near strong support, ideally just after that support is tested and holds, and the trend resumes.
- Select a position size that doesn’t risk more than 1-5% of your account in any one trade. Conservative position sizing allows you to survive the inevitable losing streaks with both you funds and confidence still intact.
One of the keys to trading success is to survive the learning period. The shorter learning curve and far simpler planning of exits, risk and money management issues make that survival much more likely.Lower, More Controlled Risk
Risk IS more defined and thus controlled than with spot market instruments, and is often lower than with standard options.
- With spot instruments, even stop losses can be rendered useless if price gaps past them and hands traders larger losses than anticipated. For those who don’t use stop losses, risk of loss rises, and is at times theoretically unlimited.
- With standard or plain vanilla options, risk is limited to the cost of the option purchased.
- With binary options, risk is usually limited to less than that, typically 85% of the cost of the option, because most binary option brokers return about 15% of the cost of the option on losing trades. The exact percentage varies with the broker.
Is risk lower with binary options compared to spot market trading? That depends on the trader.
IF we’re referring to the elite spot market traders skilled at exit planning, as well as risk and money management, and disciplined enough to do so consistently, these traders could keep their draw downs from losing trades well below the usual 85% loss with binary options, even with use of some leverage.
However, as we discuss in Chapter 3 below, that’s a mighty big IF.
Indeed, it doesn’t appear to apply to most traders. As described and illustrated in Chapter 3 below, the evidence suggests that they’re unable to exploit the potential for smaller losses from losing trades due to the complications involved. For that majority, the far greater simplicity of binary options keeps overall risk lower when they’re traded prudently.No Spreads Or Commissions
True, binary options brokers earn their money on the difference between what they pay out for winning and losing trades. See Chapter 5, the section on No Spreads Or Commissions.No Experience Required
Yeah sure, to open an account. But to make money? Please.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING DECISIONS LIES SOLELY WITH THE READER. IF WE REALLY KNEW WHAT WOULD HAPPEN, WE WOULDN’T BE TELLING YOU FOR FREE, NOW WOULD WE?