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Binary Options Trading Strategy

Instructor: Ian Lord

Ian is a real estate investor, MBA, former health professions educator, and Air Force veteran.

Binary options allow investors to create returns on the basis of whether a yes/no proposition regarding an underlying asset will occur. In this lesson we'll look at binary options basics and trading strategy.

Binary Options

Fred is looking for a way to get actively involved in investing and has been seeing a lot of articles come up in the news discussing binary options as a way to make a lot of money in the market. Binary options trading is a very different process compared to trading stocks or mutual funds. Part of Fred's necessary research will be to clearly understand what binary options are as well as how trading them can be used to make a profit.

Definitions

A binary option is a contract financial product which pays out if an underlying asset or index is priced above a certain amount at a specific time. At the expiration time, if the index is less than the target or strike price it is worth $0, but if it is above that price then the investor will receive $100. These contracts are bought and sold over the Nadex Exchange. The price changes according to whether or not investors believe the underlying asset will go above the strike price. Prices ranges from $0.00 to $100.00, which corresponds to the market's belief, as a percentage, that the strike price will be reached; a $25.00 price means investors think there's only a 25% chance that the target price will be reached.

Example and Strategy

Fred decides to get his feet wet with his first binary option. At 9 AM he sees a binary option contract for the S&P 500 Index to be above $2,341 at 1 PM. The quote for the option includes a bid price which shows what an option contract can be purchased for and an ask price which shows what the option can be sold for. It currently has a bid price of $85 and an ask price of $89, indicating it is likely to reach the strike price of $2,341 and remain above it by the 1 PM deadline. The spread allows for the exchange to make a profit on each transaction, in addition to the contract fees. To buy a single contract, he will pay the $85, plus a $1 fee.

It's now noon and Fred has a choice to make. The ask price is now $95. He has two options. He can sell the contract for $95, less a $1 contract exit fee. If he does this he will be in the money or have locked in a profit of $8 ($95 - $85 - $2). Selling a contract prior to the expiration can help minimize losses or lock in profits. Fred can also hold on and wait until the expiration.

At 1 PM the S&P 500 is worth $2,343. Fred has finished the contract in the money, and gets the $100, less the $1 exit fee. His profit on this deal is $13 ($100 - $85 - $2). But what if in the last minute the index drops to $2,340? Well, now Fred's contract is worth $0. The good news is he doesn't have to pay an exit fee. The bad news is he is out the $86 he paid to purchase the contract, also known as out of the money.

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