The Dummies Guide to Trading Binary Options

Binary Options can be either a great introduction to trading financial markets due to their simplicity and limited risk they place on capital or an hedging tool for more experienced traders. They’ve grown massively in popularity over the past several years and the binary options market has matured considerably in terms of competition, the quality of brokers offering the instrument and the product itself. As well as classic binary options, traders now have access to variations on the standard format, a much wider range of tradable markets and great tools and resources.

However, as a risk based investment, beginners considering trying binary options should be fully aware of the instrument’s characteristics, advantages and disadvantages and the potential pitfalls to watch out for and avoid. In this piece, we’ll look to provide a complete beginners guide to binary options covering:

 

 

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What Exactly Are Binary Options?

A simple form of financial instruments derivative, binary options allow traders to speculate on whether the price of a given financial instrument eg. EUR/USD or gold, will rise or fall by the end of a fixed time period. Classic binary options are as simple as that and only have two outcomes. If the trader has predicted the price will rise or fall by the option’s expiry point and it does, the option finishes ‘in the money.’ In this case, the trader wins a pay-out which is usually between 70% and 90% of the original stake. If the trader predicts the price direction wrongly and the option is ‘out of the money’ at the time the option expires, they whole stake is lost.

This differs from CFDs trading or spread betting which can lead to uncapped gains or losses depending upon how much higher or lower the instrument falls from the moment a position is opened until it’s closed. These forms of trading also allow for the use of leverage, which multiplies gains, or losses, from the original sum of money staked on the position.

Binary options are classified as ‘exotic options’. They differ from traditional ‘vanilla’ options in that the degree of price movement, unless a more sophisticated variation is used (though it is still limited), is irrelevant. The trader need only get the general price direction right, or wrong, to finish ‘in’ or ‘out’ of the money and the potential gain or loss is fixed at the outset.

In the UK binary options are, like spread betting, classified as gambling and so brokers fall under the remit of the Gambling Commission rather than the FCA. In other territories, they are classified as a financial instrument and regulated by financial regulators. Like forex and CFDs, many brokers operating in the UK and the rest of the EU are regulated by the CYCSEC, the Cypriot financial regulator and operate in other countries under the EU’s financial passporting system.

Whether binary options are speculation (gambling) or trading a financial instrument is a matter of the subjective classification in the particular country a broker is operating in. Spread betting and CFDs trading are almost identical and carry exactly the same risk and rewards but on a couple of technicalities the former is classified as gambling in the UK and the latter trading a financial instrument.

Long before being offered as a retail trading product, binary options were being used by financial institutions and were particularly popular with insurance companies as a way to hedge their exposure to major events such as extreme weather events or earthquakes. It is a fact that the way retail binary options products are created with payouts for successful trades always being less than the loss of an unsuccessful trade means that the odds are slightly in the favour of the broker.

Whether one decides to classify binary options trading as a form of gambling or as a financial instrument, it is a risk-based activity that can lead to either gains or losses. As such it is imperative that traders approach binary options with respect and understand that they can lose money as well as gain.

Binary Options Advantages

Like anything financial instrument, binary options as a tradable retail product, have their strengths and weaknesses. They are a great, accessible introduction to financial markets trading for beginners, an enjoyable stand-alone product for many and a good hedging instrument for more experienced traders. The biggest pluses to binary options trading are:

  • Accessible Entry Level Financial Markets Trading: because only the price direction has to be right to make a gain from a trade and losses are limited to the initial investment, binary options are a good way for beginners to introduce themselves to trading financial markets.
  • Losses are Limited: traders cannot lose more than the value of their position. For traders who don’t know yet if they have the psychological disposition to expose themselves to leverage, and the potential to lose multiples of the value of the trading position taken, binary options are a good low-risk option. They are also a controlled environment for more experienced traders who realise they have issues maintaining good trader psychology when offered to option to use leverage.
  • Risk/Reward Analysis Simplified: knowing at the point a trade is placed what will be lost if it finishes outside of the money and what will be gained if it finishes inside the money makes risk/reward analysis of a trade much easier.
  • Short time-frame: while longer time frames are often available, the expiry time of classic binary options is usually between one trading day and a couple of hours. This means good trades can quickly build up a trading account balance and any losses can be written off. It also means taking enough positions to spread risk well can be quickly realised.

Binary Options Disadvantages

  • Short time-frame: one limitation of trading binary options is the other side of the coin to the final advantage. Trading shorter time-frames means it is good to have a basic understanding of technical analysis of financial instruments. Over shorter time frames this is more influential than fundamental analysis on long term strength. Technical analysis is a skill that most new traders have to learn from scratch even if they have good general knowledge of financial markets and economics.
  • Broker Edge: the methodology of setting pay-out percentages in relation to invested stake gives the broker a slight advantage. Traders have to win more trades than those they lose in order to realise gains.
  • Simplicity: again the other side of the coin to advantages to binary options. Their simplicity, while a strength in many ways, is also a limitation. More complex, layered trading strategies are not best suited to binary options as an instrument.

Choosing a Broker

Unfortunately, as a result of the fact that binary options are not treated as a financial instrument in some territories, brokers are not always regulated by regional financial regulators. This means that not all brokers uphold best practice in terms of customer service and as custodians of client funds. There is also a broader range when it comes to quality of trading platform, functionality and overall quality than would be the case if all brokers were regulated by financial markets regulators.

There are many big brokers that also offer CFDs trading that are regulated by local financial regulators, as companies, even if their binary options product does not fall under the same regime. These brokers usually apply exactly the same best practice standards to their binary options trading business as to their CFDs product and are both financially reliable and generally ethical. There are also unregulated brokers that offer both a great trading and customer service experience.

However, there are also less scrupulous or quality operators so it is important for traders to research a broker well before opening an account with them and depositing money. Researching the quality and features offered by trading platform is important to judge if it meets requirements as is looking at different reviews left by other traders on qualities such as ethical professional standards and levels of customer service.

Preparation

As with any form of trading or investing, the key to success in binary options trading is education and having the correct mindset. The easiest way to have a bad experience is to jump in and speculatively take positions with real money based on hunches or backed up by insufficient knowledge.

New binary options traders should take the time to research fundamental and technical analysis techniques and learn specific trading skills, as well as more general financial markets education. Understanding the psychology of trading is also important as is how to manage funds and spread risk, which we’ll conclude by addressing specifically.

Researching the reputation of brokers and if their trading platform is the correct fit for your profile, requirements and preferences is also key to the best trading experience possible. Finally, especially for beginner traders, the best advice possible is to spend plenty of time trading in a demo environment and feeling completely comfortable and sufficiently competent before switching to real money.

Don’t Lose All Your Capital!

Success or even educational and constructive failure in any kind of financial markets trading rests on spreading risk and trading in a controlled fashion to limit losses. Binary options trading is no different and the golden rule for beginners is always to control losses as the platform to potential gains. The best, most experienced traders in the world lose their share of positions. Being a profitable trader always means also losing trades. With binary options, it’s about taking more wining positions than losing over a period of time.

As a beginner, it is almost inevitable to lose. There are probably a tiny number of financial markets traders in the world who returned a profit from the very beginning. It takes time and experience to learn and be able to successfully implement theoretical lessons and maintain the right psychology to become a consistently profitable trader. To an extent, taking some losses along the way is inevitable as trading a demo doesn’t involve the same psychology as trading real money. The key is limiting those losses to small, affordable amounts and not losing all an account’s capital quickly. This will provide enough time and experience to learn the ropes and develop the skills to be eventually profitable within a reasonable budget.

While learning the skills required to read financial markets and their likely direction, particular attention should be paid to capital preservation and good risk management.