By InvestingChannel, Sponsored by NADEX

If you are drawn to the excitement of trading action where you can capitalize quickly on your market insight, then binary options may be just what you've been looking for.

Unlike standard options, binary options only have two possible outcomes - you're either right or wrong at expiration (unless you close out your position before expiration to take early profits or cut losses), and only one side of the trade can receive the $100 payout per contract. With binary options, your dollar risk exposure and net payout are clearly defined when initiating the trade.

Going Long the Binary!

Consider the E-mini S&P 500 futures index®, currently trading at a level of 1775. Let's say that you are bullish on the stock market and you expect the futures market to trade above the 1800 level by day's end. Assume at this time, you're not comfortable trading the futures outright because you think the market is going to be very choppy and eventually grind higher but you don't want the exposure risk or frustration of continually getting stopped out. That being the case, you notice that the Nadex US 500 > 1800 binary option which is based on the E-mini SP future is trading for a value of $31. Heres what that means:

  • If the E-mini S&P 500 Index future finishes above 1800 at the end of the day, the binary option pays $100 to the binary buyer
  • If the E-mini S&P 500 Index future finishes at or below 1800 at the end of the day, the binary buyer gets nothing; instead the seller of the that binary option collects the $100

Scenario Breakdowns: Remember you paid $31 for the option; your P&L is as follows:

  • If the Nadex expiration value is greater than 1800, you get paid $100 per contract. Since you paid $31 to buy the binary option, this leaves you a net profit of $100 - $31 = $69(not including exchange fees)
  • If the Nadex expiration value is at or below 1800, you simply lose your initial $31 investment

If you decide to get out of the trade early, prior to expiration, you are long the binary trade price at 31 so if the binary is trading higher than 31 or lower will reflect your P&L depending on your exit price. The binary pricing scale trades between 0 to 100 and is reflective of the underlying relative to the binary strike. The higher the underlying is trading over the strike, the closer to the binary is priced toward 100; and the lower the underlying is trading below the strike, the closer the binary is priced toward 0.

The beauty of binary options trading is the simplicity. The risk and reward payout out ratios are very clearly defined to make it easy to decide if the trade suits you. You don't have to get caught up in the option Greeks as the binary trade price reflects a probability of the outcome.

Go Short!

So what if you don't think the market can settle above the 1800 level by the end of the day today? In this case, you can sell the US 500 > 1800 binary option. For the sake of simplicity, let's assume that you can sell the option at a level of $31. Then, this would be the breakdown of your trade:

  • If the E-mini S&P 500 Index future® finishes above 1800 at the end of the day, the binary option pays $100 to the binary buyer. You sold the binary at a 31 trade price so your initial cost was $69 your maximum risk to the trade (100 - 31 trade price). As a binary Seller, worst case, you would lose the maximum of $69 plus exchange fees
  • If the E-mini S&P 500 Index future finishes below 1800 at the end of the day, the binary value is zero and buyer gets nothing and you, as the binary seller, will receive a $100 payout per contract. The seller's initial cost was $69 so the net profit will be $31. Remember all binary trades on Nadex are fully collateralized.

Remember, you pay your share of the full value of the contract when you buy or sell a binary option, it is important to note that your initial binary trade cost as a buyer or a seller is always your maximum risk exposure to the binary trade and the difference from the $100 cap notional value is the net profit at expiration. The initial binary cost is reflective of the immediate trade advantage or disadvantage relative to the underlying price level compared to the strike price level.

Final Thoughts

By their very nature, binary options have a lot less moving parts than standard options. There are only two possible outcome and you know both of the outcomes ahead of time. Keep in mind that there are transaction costs such as the exchange trading fee or expiration fee but if the binary expires worthless there is no additional fee cost. In sum, the simplicity of binary options serve as a refreshing and revolutionary way to approach today's markets.

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

To learn more about NADEX Binary Options, Click Here