Binary Options Offer A Simplified Form Of Speculating Financial Markets
There is a lot of difference between standard equity options and binary options. Really, the only thing about binary and equity options that is the same is that they are both tied to an underlying asset. Beyond that the differences are vast and account for why equity options are so difficult to trade profitably. There is quite a bit more to trading options than what the T.V. ads would lead you to believe. It takes more than a fancy computer set up and the “best charting package there is” to profit from trading that type of option. There are many headwinds that keep the average trader from profiting in the options market, headwinds that binary options alleviates.
Binary Option - A speculative financial instrument with only two possible outcomes, both based on the price of an underlying asset. If the asset closes in the money the option pays the maximum return. If the asset closes out of the money the option expires worthless. Binary options are cash settled, do not have any intrinsic value and offer a fixed rate of return. Traders buy calls if they are bullish and puts if they are bearish. Expiration times can vary from broker to broker but usually range from one hour to end of the day, week or month. There are no contracts in binary options, bigger trades are made by investing bigger sums of money per position. The price of the underlying is the strike price when you purchase a binary option. With European style binary options positions are held until expiration with no ability to close positions prior.
Equity Option A derivative financial instrument used for speculation and hedging. Equity options do not offer a fixed rate of return. The value of equity options is based on many things including the price of the underlying asset, strike price and volatility. Prices are derived using the Black-Scholes Model and are heavily weighted in the favor of the market maker. Equity options are sold in contracts, each contract grants the owner the right to buy or sell 100 shares of the underlying stock; equity options can have intrinsic value. In order to place a bigger trade you must buy more than 1 contract. Price is also determined by factors such as strike price, delta, theta and volatility. Equity options have many strike prices, not just one, and expire monthly up to several years out.
Let’s take a look at the difference between an equity options chain and a binary option chain. The biggest difference between them is that binary options do not really have a “chain”. Since there is only one strike at any given time, the price of the underlying, there is no need for a complicated chain of prices. Binary options only have an order screen with two simple choices; call and put. Looking at the option chain for Ford Motor Company we can see that there are 16 different strike prices listed, all with different characteristics. Notice the bid/ask spreads and the open interest. The bid/ask spread is the difference in price between buyers and sellers at any time. This difference is the profit taken by the market maker. Open interest is the number of open contracts in an option, the bigger the number the more liquid an option is. Please keep in mind that this chain is only showing calls. There are at least as many puts available as well.
Now let’s look at the order screen for Toyota binary options. I have chosen the nearest expiration which is 11:10. This “chain” is much simpler and easier to read. There is only one strike price,the price of Toyota at that time. There are only two choices, call or put. If a call bought at this time closes in the money at 11:10 then the trader profits 68%. Binary options have a fixed return, this is much different than for equity options. Because of the nature of equity options it is possible for an option to close in the money and for the trader to lose money.
There are other factors of equity options that keeps the average investor from profiting. In fact, most equity options traders find that the deck is stacked against them. It is said that more than 2/3 of all equity options expire or are closed out worthless or for less than they were purchased for. The factors causing this are moot when trading binary options because they don’t apply. Things like volatility, the Greeks and slippage are only a few of the complex factors that can affect the value of an equity option and do not affect binary options. Delta is one of the Greeks. It is the amount the price of an option will change when the underlying moves $1. If an option has a delta of 0.50 it will gain $0.50 for every dollar the underlying stock moves. With binary the underlying only has to move one penny in order to receive the maximum return. Another Greek that is a drag on equity options and not present in binary trading is theta. Theta is the amount of value an option will lose in one day. A theta of 0.05 means an option will lose $0.05 today. Each day that passes causes theta to increase. An equity option will lose a little more tomorrow and a little more the day after that. Notice the differences in delta and theta between the in-the-money and the out-of-the-money options on Ford Motor Company.
The two Greeks I have described are compounded by volatility and slippage. Volatility is the amount of movement a stock is expected to make. The higher the volatility the higher the price of the option. If volatility, and more importantly implied volatility, suddenly drop then the value of your option will suddenly drop. Looking at the chart of Ford Volatility we can see historic and implied volatility charted along with stock price. When implied volatility is higher than historic volatility then the options are said to be overpriced. Slippage is the difference in price between when you set your order and when it executes. Financial markets can move fast and it is possible for factors to change in the blink of an eye. It is possible to set a market order for an option when it is listed for $0.75 and get a fill price for $0.85 or higher.
There are many who will say that binary options are pure gambling and that they are a risky investment. The truth is that binary options are no more risky than equity options and may in fact be a better way to speculate the market. After all that I have gone through I am sure it easy to see just how much simpler binary option trading is. There is just one screen and two choices. There are no tricky Greeks or implied volatility to suck the value out of your options. The technical analysis remains the same but the choices are much easier to make. I think the only argument left that could possibly derail my opinions on the merits of binary trading is regulation. The binary options industry is making big strides in the area of regulation, making binary trading more attractive every day. Click here for more on the regulation of binary options.