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Binary Options vs. Options
Binary Options vs. Options, if you are new to trading then you may be slightly confused.
What is a binary option and how is it different from a traditional vanilla option?
This is indeed an important question as one cannot really be expected to make money trading either without having a theoretical understanding of how they work and what characteristics they share.
You cannot simply jump into binary option trading without knowing where it came from. We will go through the differences and similarities between binary options and traditional options in depth.
What is an Option?
An option is a financial instrument that is a derivative on another asset. This means that is derives it’s value from the value of some underlying asset. An option gives the holder the right but not the obligation to buy or sell the underlying asset at some predetermined time in the future. This is why they differ from other derivative instruments such as Futures. The holder of the option does not have to execute on the underlying contract if it is not profitable for him to do so.
Options can be written on a range of financial assets from Equity, to commodities, Forex, interest rates and even bonds and credit ratings. Options contracts are by no means a new phenomenon in the financial world. They have existed for hundreds of years and first started being offered in ancient Greece as a way for farmers to hedge their olive crops. Since then, they have been used in commodity circles for a number of years.
People then started to trade options on equities (stock options) and interest rates (Swaptions). These then evolved into an asset class in their own right which culminated with them officially being traded on the Chicago Mercantile Exchange in 1973. This created a large market for them with full liquidity similar to how traditional stock markets would operate.
Some Option Fundamentals
Option theory can be quite a complicated discipline but there are a few fundamental factors that one needs to know about in order to trade them. Some of these are more relevant for quantitative traders than others but it helps to have an overview of them all.
Current and Strike Price
The Currency price (S) and the Strike price (K) are two really important inputs in determining the option price and payoff. The current asset price is self-explanatory and is the price that is prevailing in the market for the asset. The strike price is the agreed upon price that the option holder will either buy or sell the asset at expiry.
Time To Expiry
This is the predetermined time in the future when the option expires. If the trader has entered into a European option, then this is the only time at which they can exercise the option (their right) to either buy or sell the security. This is in contrast to the American option where a trader can exit at any time prior to expiry.
The option expiry time can range anywhere from end of month to a few years in the future. Option expiry time is also an important point in pricing options as it plays a large role in the time value of the option. This is the notion that, all things held equal, an option with a longer time to expiry is worth more.
CALL or PUT
When someone enters a CALL option, they are purchasing the right to buy the asset at some pre-determined rate in the future. When someone buys a PUT option, they are getting the option of selling some asset at some time in the future. Hence, one can think of the CALL option as a trader taking a bullish (long) view on the asset and the PUT option as the trader taking a bearish (short) view of the market.
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There are two terms that you will hear frequently when trading options. Those are In-The-Money (ITM) and Out-Of-Money (OTM). In essence, what it implies is if it would be profitable for the trader to exercise the option at the current price level. When the trader holds a CALL option, it is in the money when the price of the asset (S) is above the strike price (K).
Conversely, a PUT option is in the money when the price is below the strike. Out of the money options occur when exercising the option is not worth it for the holder and they would rather let the option expire worthless.
Option Volatility (σ) is also an important factor when pricing options. This is because volatility can impact the price movement of the asset to a large degree and hence the option price as well. Volatility is a measure of how much a price moves around a mean. Generally speaking, options on assets with more volatility are more expensive as there is more chance that the price will swing wildly in or out of the money
At the expiry time of the option, the holder will get a certain payoff. This will only be positive if the option has indeed expired in the money. The payoff will be the difference between the asset price and the strike price (S-K) if it is a CALL option. The payoff will be (K-S) if it is a PUT option.
The option premium is another term for its price. The reason that it is termed a “premium” is because one can think of it buying protection similar to the protection that one buys with insurance premiums. When a trader buys an option, the maximum that they are going to lose on the trade is this premium amount.
We will take a look at a graphical example of a call option payoff in order to help cement your understanding of how an option would work.
In the image on the right we have a CALL option. The price of the asset is plotted on the x axis and the Profit / Loss is plotted on the Y axis.
We can see that the strike price (K) of the option is at 110. Looking at the payoff structure, one can see why options have an asymmetric payoff. The maximum loss that the trader can lose is the option premium when the option is out of the money.
On the upside though, the potential profits from holding the option are unlimited. This is the reason why options can be such a profitable derivative instrument.
Of course, this is rather simplistic as the option price does vary according to the time to expiry and the volatility in the underlying asset.
Benefits of an Option
Given the nature of the payoff and the way that options are priced, there are a number of benefits from trading options. Although some of these are more applicable to sophisticated investors, retail traders can learn from them.
The Trader is in effect taking a leveraged trade on the asset to the upside. When the trader pays the premium then they could theoretically gain a large payoff if their trading turns out the way that they predicted.
Options have a certain degree of surety around them as the trader knows with certainty the maximum loss that he / she is likely to incur in the case of a downside event. This is the option premium that was invested.
Given the asymmetric payoff that one can see for an option trade, this means that the trader can use a number of bespoke option based strategies. These include such strategies as bull / bear spreads and option flys
Trade any Asset
When trading an option, you don’t have to hold the underlying asset. Therefore a trader can take a position on an asset that they cannot physically buy. For example, if the trader wanted to take a long position on the S&P 500 index, they can merely by a call on the index
Trade Underlying Volatility
This may be more applicable for the sophisticated investors who would like to trade the underlying volatility of the asset. In the financial industry option trading desks are often termed “volatility” traders. This is because volatility has a large impact on option price and hence traders can take a view on it
What is a Binary Option?
Binary options share all of the same underlying factors as traditional vanilla options. When pricing binary options, the same inputs are used to determine its value. The only way in which they differ is their pay-out structure on expiry.
On expiry of a binary option, the pay-out of the option is only one of two outcomes. That is either 0 or 1 (100). This is why it is sometimes termed “binary” or “digital”. These are the basics of binary options and how their payoff is determined. This is in contrast to the vanilla option where the payoff is indeed variable on the upside.
We have included an image on the right that is the pay-out of a binary option on the expiry of that option. Unlike with the traditional options, the payoff is capped at a certain amount. This means that no matter how high the asset price goes, this will be what the trader will gain.
Binary Options have been traded Over the Counter (OTC) by large investment banks and hedge funds for a number of years. They were also considered quite difficult assets to trade due to the nature of their payoff. The large market makers who were trading Binary Options with millions in notional found it hard to hedge the binary outcome.
Retail Binary Options Market
It was not until about 2008 that Binary Options started to gain a large degree of interest from the retail market. Average investors who previously had traded Forex and CFDs now had the opportunity to trade a different type of instrument. They did not need to know about the underlying option theory in order to take a “bet” on the direction of the asset.
Binary Options trading then took on a different form and could allow traders to enter a trade with expiry times of as little at 1 minute which was unheard of in the option industry. Binary Option trades were also simplified down to the point at which the trader could merely decide whether the option was going to go up or down in the next few minutes.
Payoff was also determined as a percentage “win” on the trade. Hence, if the trade ended up in the money then the trade would get a payoff that ranged from 50%-80% of the amount that was staked on the trade. Retail binary options also operated as a European option variant where the trader had to wait until expiry. This is in contrast to most traditional vanilla options where execution can be done prior to expiry.
Indeed, there were a number of traders who merely traded binary options on a hunch and this was more gambling than investing. Binary Options trading morphed from a complicated derivative instrument that investment banks struggled to hedge into a quick and easy way for retail traders to enter the market.
Benefits of a Binary Option
Even though most traders sometimes treat binary options as a mere bet on the movement of the underlying instrument, they do enjoy this form of trading. Unlike traditional option trading, the trader does not have to monitor the underlying factors that impact on the price of the option such as those we mentioned above.
They don’t have to necessarily study the dynamics of option pricing in order to do relatively well trading binary options. They merely have to have a view on where they think the asset is likely to go based on a number of different trading signals and indicators.
Moreover, traditional option trading is not easily available to most retail traders. This is because there are usually quite large minimum account requirements to maintain a vanilla option account. However, Binary options brokers have much lower account requirements that start as low as $10 for some.
If you are a relatively new trader who would merely like to take a view on some asset over a very short period of time then you may be better suited to trading a binary option. However, if you have more funds available and would like to learn about trading options fundamentals then traditional vanilla options could be for you.
Traditional Options Versus Binaries
Trading options is seen by many people as a safe way to speculate on asset prices. In the traditional sense, an option gives you the freedom, but not the obligation, to buy a set amount of an asset at a previously determined price. If the price is right, you can execute the trade and make a profit. Call options are for when you think the price of an asset is going to go up. With these, you agree with a broker on a low price. If the actual price goes above that set amount, you can buy the lot at the lower price and then immediately turn around and sell the lot off at the higher market price. A put option works similarly, but in the opposite direction—so if the price drops, you will be profitable.
Risk Warning – “Investors can lose all their capital by trading binary options”
The luxury to be able to make this choice is not free. There is a contract price that you must pay, usually determined by how many individual units of the asset you are buying and how far away the expiry is. Because you may execute your option at any time prior to the expiry, the further away the expiration date is, the higher the contract price will be.
Let’s look at an example. Assume you want to buy 1,000 units of Cisco stock. Cisco is currently a $23.00 per share, and you think that it will go up to $26.50. Buying this quantity of stock would typically cost you $23,000 up front, and if Cisco drops in value, you stand to lose a lot of money. But if, instead of buying the stock in the traditional sense, you want to exercise an option, your investment will be much smaller. Assume you can find a six month option a $23.50 per share. When the price reaches your goal of $26.50, you can use your option rights and see a profit of $3,000.
The minus is that a contract costs money. It might be only around $10 for the contract, plus $1 per share. For 1,000 shares, you would be spending $1,010 for the right to make your trade six months from now and profit by $1,990. This might seem like a lot of money for a possibility, but think about it this way: if you bought the share normally and they went down $2 per share, you would lose $2,000 right away. Options offer an extra layer of protection that the stock market does not.
Do not confuse traditional options with binary options. Binary options are not true options because you never actually take ownership of the asset. You also do not have the freedom whether or not to execute the trade at a later time. When you buy an option, your choice making ability (in most cases) vanishes. You must simply wait until the expiration time to see whether you were profitable in your decision or not. You can also trade bitcoin and ethereum with binaries, but not so much in traditional options.
Binary options offer even more protection than traditional options do. You won’t have to ever shell out $1,000 to execute a trade if you do not want to. And if you do decide to trade with this denomination, you will know exactly what your profit rate will be. There is very little guesswork in binary options as the broker stipulates all of the variables prior to the trade’s execution. The only question mark is whether the asset is going to go up or down. This is where you step in as a trader. This should make your job easier since there are few variables that you will need to estimate before you actually begin actively trading.
Binary Options vs. Options
Posted on October 29, 2020 by J Crawford in Education, Options | 0 Comments
Binary Options vs. Options
What is the difference between binary options and options?
In case you’re just learning the ropes about trading, you might struggle to tell Options and Binary Options apart.
Before you invest in something, it’s always advisable that you try and learn as much as you can about it, so that you understand the investment vehicle you’re putting your money into and the features.
Understanding binary options and the conventional options, you have to take the time to learn the differences between these in-depth before you can invest your money.
What Are Options? Options Trading 101
Options are derivative financial instruments, in that they depend on other assets. The value of an option depends on the value of another asset. Options give the holder a right, but not obligation to buy or sell the underlying asset at a given time in the future. This is one of the main differences between options and other derivatives like futures. As an option holder, you do not necessarily have to act on the underlying contract if you feel it is not going to be profitable for you in the long run.
There are so many financial instruments upon which options can be written, including credit ratings, bonds, interest rates, forex, equity, and commodities. For hundreds of years, options have been used as financial instruments for different reasons. Some of the earliest known options were used in Greece by farmers who would hedge their olives. Since then, options have advanced and have been used as financial instruments in several instances over the years.
Options would, later on, evolve to be traded on equities as stock options, and interest rates as swap options. Later on, they evolved into a unique class of assets and were eventually listed in the Chicago Mercantile Exchange in 1973. This exposed options to a large market from where they gained complete liquidity as would assets in traditional stock markets.
While the concept of options might not be very easy to grasp, there are some options basics that you can learn, which will go a long way in helping you learn how to trade in options and option trading strategies . Whether you are a quantitative trader or not, mastering these concepts will help you secure better returns from your investments, especially if you are trading options for income or trading options for a living.
- Current and Strike Price
The current price (S) and the Strike price (K) are two of the most important factors that are used when determining the payoff and price for the options. The current asset price is the price at which the asset is available in the market. This is self-explanatory. The strike price, on the other hand, is the price that is agreed upon, at which the option holder might sell or buy the asset when the option expires.
- Time to Expiry
This is a preset time in the foreseeable future upon which the option will expire. In European options, traders are restricted at this time, as the only moment in time when they can buy or sell the options. American options, on the other hand, are more flexible, allowing traders the freedom to exit the trade at any given time before the option expires.
The time to expiry exists within a range and can be a few weeks, months or even years into the future. The expiry date is also important in setting the price of the options. Holding all factors constant, options that exist for a longer period are usually more valuable than short-term options.
When you invest in a call option, you are buying the right to buy the underlying asset at an agreed rate in the foreseeable future.
Puts, on the other hand, give you the option of selling the underlying asset at a given time in the foreseeable future. A call, therefore, can be viewed as a bullish (long) perspective of an asset while a put is the opposite, a bearish, (short) perspective of the market.
- Option Moneyness
When options trading, you will come across two important terms, in the money and out of the money. What these terms allude to is whether the trade will be feasible for the trader to make profits at the prevailing price. In the case of a trader who has a call option, he is in the money if the price of the underlying asset (S) is higher than the strike price of the same asset (K).
On the other hand, a put option is said to be in the money in case the price of the asset falls below the strike price. In a situation where exercising the option would not be in the best interest of the holder, and it would be better if they let the option expire and become worthless, this is where the investor is out of the money.
- Price Volatility
When determining the price of options, the volatility of the options is another factor that is taken into consideration. Volatility determines how the value of the underlying asset changes in the market, and as a result, the price of the option. It is simply a factor that determines how high or low the price of the asset varies from a given mean.
Options that are offered on assets that are more volatile are considerably more expensive, and as a result, their prices tend to be in and out of the money from time to time.
When the option expires, the investor earns a payoff. If the option expired in the money, the payoff is positive. The payoff is calculated as the difference between the strike price and the asset price. For call options, it is calculated as S-K and K-S in the case of a put option.
The price of the option can also be referred to as the premium. It is a premium because, in essence, the investor is buying protection just in the same way that we buy insurance premiums. When the trader invests in an option, the highest amount they can lose on this investment is the amount that is marked as the premium.
An Option Illustration – Options trading tutorial
The following is a graphical illustration showing a payoff for a call option, which can help you understand how options work.
The asset price is indicated on the x-axis, while the profit or loss is indicated on the y-axis.
The option strike price (K) is 110. If we consider the structure of the payoff, from this illustration, we have an asymmetric payoff. The highest loss that the trader can risk is the premium on the option, which happens only if the option is out of the money.
A good thing about this investment, however, is that there are unlimited options for profit making. This is why most people consider options as a very good derivative investment instrument. This approach, however, takes a simplistic view, because, in reality, the price of options tends to vary depending on the volatility of the underlying asset, and time to expiry of the option.
Benefits of Investing in Options
When you consider how the price of options is set, and the nature of the payoffs, you will notice that there are several benefits that you can derive from options trading. For sophisticated traders, most of these benefits do apply. However, even for a retail investor, you can still learn so much in the process.
- Leveraged Trade
When you invest in an option, you are leveraging your trade on an asset, that the value will appraise. If you pay the premium, in theory, you should be able to get a good payoff, especially if the trade turns out in your favor.
One of the best things about investing in options is that there is always a level of security in that as a trader, you are already aware of the maximum possible loss that you might incur if the market takes a dive. This is the premium you invest when you buy an option.
- Unique Strategies
Options have an asymmetric payoff system, which means that as a trader, you can consider using different strategies to invest in options. Some of the common strategies that have been used by shrewd traders in the past successfully include bull and bear spreads.
- Trade Any Asset
You do not necessarily need to hold an underlying asset to trade in an option. For this reason, you have the chance of investing in something that you might not be able to purchase physically. If, for example, you want to invest in a long position in the S&P 500 index, you can simply do this by taking a call option on it.
- Trade Underlying Volatility
Investors who have been trading in options for a long time have a better perspective of this. By trading on the volatility of the asset, these are investors who wager their money on the effect that the price of the asset will have on the option.
Binary Option Payoff
The main features of binary options are similar to the traditional options. The same inputs apply even when setting prices for binary options. The main difference between these two, however, is the payoff structure when binary options expire.
When binary options expire, there can only be two possible outcomes, either 100 or 0. It is for this reason why binary options are at times referred to as digital or binary options. In the case of vanilla options, on the other hand, the expected payoff is variable.
In the illustration below, we have the expiry and payout matrix for an option. You will notice that unlike a scenario where we have traditional options, the payoff matrix here has a limit. Therefore, however, high the price of the asset rises, this is the only gain that the trader will make.
Over the years, binary options have always been trader by hedge funds and large investment banks in over the counter (OTC) markets. Considering the nature of the binary options payoff, some investors tend to shy away from them because they are difficult assets to trade.
Retail Binary Options Market
Confidence had been lost in binary options trading in the retail market, at least until 2008. Investors who primarily traded on CFDs and Forex were now able to use a different investment instrument for trade. These are investors who did not necessarily need to know about the underlying asset for them to preemptively wager on the direction the price of the asset will move.
Binary options trading then evolved to allow investors to trade with expiry windows as small as 1 minute apart, which was a new strategy in options investments. Other than that, the trades became simpler such that traders were able to predict the direction of the market in a few minutes.
The payoff is arrived at as a portion of the profit the investor makes on the trade. Therefore, if the position ends up in the money, the payoff would be between 50% and 80% of the principal sum that the trader invested as capital.
There are instances where retail binary options can be traded as variants of European options. This particularly applies in cases where the trader has to wait for a while until the option expires. Conversely, most traditional vanilla options can be executed even before they expire.
There are some traders who prefer binary options trading based on speculation, which simply means they are not investing, but are gambling. Investment banks struggled to reign in binary options and over time they evolved into one of the simplest methods of investing by retail traders.
Binary Option Pricing
A lot of investors consider binary options to betting on the possible movement of an underlying asset. However, it is still a form of investment that they take seriously. Compared to traditional options investments, the investor does not always have to study the factors that affect the price of the binary options.
You do not need to study and interpret all the dynamics that affect the price of options, for you to trade in binary options. All you have to do is speculatively decide on what you think the value of the asset will be and place your bet.
Traditional options trading is not common in retail trading platforms. The reason for this is because there are so many requirements to open and maintain the account. Therefore, this deters a lot of people who would want to make quick cash. With binary options, however, brokers usually have very few requirements, and you can start with at least $10.
For new traders who are looking to invest in an asset over a short period of time, binary options trading would be a good idea. If you have more funds at your disposal, you can consider investing in traditional vanilla options.
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