Binary options trading involves an investor predicting that an asset will have a particular market price on a particular date. If the investor is correct, the other party in the trade pays a fixed amount to the investor. If the investor is incorrect, he gets nothing. Although the risks are lower with this method than in traditional options trading, investors should still take care to assess both the price and the conditions of the deal before making an informed decision about whether the balance between risk and reward is acceptable.
The most important element of binary options trading is to be clear about the exact conditions of the option. The terms used are different to some other common forms of financial trading. For example, a call option is one that pays if the price is above a certain level on the agreed date, while a put option pays if the price is below the level.
Investors also need to check whether the option is European style or American style. Despite the terms, the styles are not restricted to particular markets. In European style, the more common version, the price must be above or below the designated level on the agreed date. In American style, the options pays if the price passes the designated level at any point up to an including the agreed date. This makes an American-style option much more likely to pay out, which will usually be reflected in the pricing.
As with all forms of options, investors using binary options trading need to answer two separate questions. The first is how likely the option is to pay out. The second is how well the pricing of the option reflects this likelihood. It's important to remember that the pricing is not simply how much the investor initially pays, but rather the relationship between the amount paid to get the option, and the amount received if the option pays out. This relationship is directly equivalent to fixed odds in gambling.
Investors also need to check whether a binary options trading deal is for cash or assets. In a cash deal, the payout is a fixed amount of money. In an asset deal, the payout is a fixed unit of asset, such as a particular number of shares. In European style binary options, this means the investor could wind up making more than expected depending on the extent to which the price exceeds the designated level on the agreed date. This possibility needs to be reflected in assessing whether an option makes sense.
Many investors use a formula to assess an options' value. The formula itself is objective, though of course selecting the formula is subjective. The best known is the Black-Scholes model, of which there are variations depending on whether an option is cash or asset based, and whether it is a call or a put. In all cases, the formula takes into account the current price of the stock, the designated level at which it pays out, how long there is until the agreed date, and the volatility of the asset price. The formula also takes into account the current interest rate for risk-free investing, such as government bonds, which may prove a better proposition than investing in the option.
