Binary Options - What You Need to Know
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Related: Best Stock Picking Advisors, Motley Fool Stock Advisor Review, Investment Advice Sites, Options 101: American vs. European vs. Exotic
Options are notoriously difficult to value given their flexibility, but certain types of options are easier to use than others. Binary options, also known as all-or-nothing options, provide a cash or asset payoff only if certain conditions are met. Given their simplicity, the options have grown increasingly popular over time, moving from over-the-counter to exchange-traded transactions with significant liquidity.
In this article, we’ll take a closer look at how binary options work and when traders should consider using them as an alternative means to profit.
Be sure to also read our guide Options 101: American vs. European vs. Exotic
Binary options are essentially “all or nothing” bets that an asset will reach a certain price over a certain period of time. Often times, traders use binary options as a way to speculate on a yes/no event, such as an FDA approval or interest rate decision, in order to avoid the risk of holding a physical position. The options themselves are also growing increasingly popular, which has improved liquidity over time.
For example, suppose that in February a trader believeds that the S&P 500 SPDR ETF will close above $190.00 by the end of May. While the trader could go long SPY or buy a more traditional option, they could instead buy 10 binary call options at a cost of $20.00 a piece or $200.00 in total that pay out $100.00 a piece if the price closes at or above $190.00 level by May.
There are several different types of binary options, including:
Binary options provide traders with a unique way to profit in many different markets by making all-or-nothing bets, but there are many risks and other considerations that investors should contemplate before buying or selling.
Binary option benefits include:
Binary option risks include:
See also the Ten Commandments of Options Trading
Binary options are valued with the Black-Scholes model, similar to the way traditional stock options are valued. The key difference in valuing binary options is taking volatility skew into account, which can involve a more sophisticated analysis based on call spreads. Since the skew is usually negative, the value of a binary call option is higher when taking the skew into account in valuation.
Binary options are also interesting because they provide additional insights that aren’t available when looking at a stock or plain vanilla options. In finance, stocks have expected returns already priced in and vanilla options provide the market’s estimate of upcoming volatility. Binary options add to that by showing the market’s anticipated skew – that is, patterns that arise in implied volatility.
Binary options provide traders with a way to bet on future price direction in an all-or-nothing manner, which provides a very specific risk/reward profile. Traders should carefully weigh the many risks and rewards associated with binary options, including diversification and liquidity concerns. Valuing binary options is similar to plain vanilla options, but must account for volatility skew, which provides interesting insights into the market.
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