Binary options are financial derivatives in which the payoff is either a fixed monetary amount or nothing. Binary options have previously only been available to institutional investors and large corporations and were mainly used for currency hedging purposes. However, binary options have recently also become available for retail investors who are looking to place bets on stocks, bonds, commodities, currencies or indices.
How do binary options work?
Online binary options brokerages, such as Morton Finance, always quote binary options with a two-way price. An example would be 49.50/50.50. If you want to go ‘long’ and buy a binary option on the underlying asset (such as a stock, commodity, currency or index), you buy it at the offer price, which would be 50.50. Should the underlying asset close up within the pre-defined time horizon (say 5 minutes) your profit would be 49.50 times your investment per point (say USD 5). So, if we were to buy USD 5 per point at 50.50 and the underlying asset closes higher after 5 minutes, we would generate a profit of USD 5 * (100-50.50) = USD 247.50. Adversely, if the underlying asset would end up lower after 5mins, then you would make a loss of USD 5 * (0-50.50) = USD 252.50. The value of a binary option at expiry is always either 0 or 100. Therefore, your potential loss is limited, which helps you manage your loss exposure when trading binary options.
Binary options trading strategies
However, as with all financial trading, it is important to have the right strategies in place to ensure the highest chance of consistent profits. Due to the short-term nature of binary options markets, they are best traded when there is a clear short-term trend in asset prices. That way you have a good chance of profitably closing out 5-minute or 10-minute binary options trades.
- Trade on the back of company news
Important company announcements, such as better-than-expected or worse-than-expected earnings releases, provide a great opportunity to put on binary options trades as they result in sharp price movements for a short period of time. You can capitalize on such mini-trends by either buying or selling a binary option on the company’s stock depending on whether the company announcement was positive or negative for its stock price. For example, if Goldman Sachs announces worse than expected results, its stock price will drop immediately after the announcement. In this situation, you could sell a binary option on Goldman Sachs stock and will very likely close out a profitable trade.
- Trade on the back of economic data announcements
You could apply the same strategy to macroeconomic data and use stock indices as an underlying asset to put on binary options trades post market-moving economic data announcements. For example, if you trade the S&P500 using binary options you can go long after better-than-expected US economic data has been released or go short immediately after worse-than-expected US data has been announced. Hence, if there are better-than-expected US unemployment numbers you can go long the S&P500 using a 5-minute binary option and profit of the immediate jump in US stock prices.
- Trade on the back of central banker announcements
Alternatively to economic announcements, you could also apply this strategy to central banker announcements, which have been making in an increasingly high impact on asset prices since the 2008 financial crisis. If a central banker of a major economy such as the US, the UK or Europe hints at future rate cuts or hikes, this will cause a large movement in stocks prices, thereby creating a great opportunity to capitalize on immediate price trends using binary options.