Ian is a 3D printing and digital design entrepreneur with over five years of professional experience. After six years of aircrew service in the Air Force, he earned his MBA from the University of Phoenix following a BS from the University of Maryland. He is also a real estate investor, board gamer and homebrewer.
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.
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.
Fred can tailor his strategy to his own comfort level with the risks, such as exiting the contract as soon as it reaches a desired profit, diversifying among different contracts, or setting specific buy and sell limits for himself. He can monitor the market news or look at past performance to identify trends in the market which he might be able to take advantage of to buy at the lowest possible price and sell at a high profit. Past performance isn't a guarantee of future performance but it can help investors learn how the market has reacted to past events. Since the contracts are dependent on an underlying asset, it is helpful to understand what is going on by staying informed about current events that affect that asset.
Investing in a binary option involves a contract where the option holder receives $100 if the the strike price for a given index is reached by a specific expiration time. The contract can be bought at the bid price and sold at the ask price over the Nadex exchange for an entry fee of $1 plus an exit fee of $1 if the strike price is reached or if the contract is sold to another investor. The price of the contract ranges from $0.00 to $100.00, with a higher value indicating the increased likelihood that the contract will hit the strike price and pay out. At expiration, an option is either worth the $100 it would pay out or $0 because it failed to reach the strike price and is now worthless.
Contracts can be sold at a profit or loss prior to the expiration, which can be effective at managing investment risk. When an investor can sell the contract at a higher price than was paid for it, or the strike price is reached on the expiration, the investor is said to be in the money. A loss is called being out of the money.
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