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Binary Options 101 - An Introduction to Binary Options Trading

01/19/2016 01:21 pm ET | Updated 1 day ago

What exactly are binary options?

Binary options are simply a financial instrument that give a trader to purchase an option based on how the traded understands the movement of a price of an underlying asset. It is similar to more traditional, vanilla options because it is also an agreement between two parties to CALL or PUT on a financial security at a specific price or within a certain expiration period. With binary options the two parties are the trader and the binary options brokerage firm.

The amount of return you receive on a CALL or PUT option is an agreed upon percentage based on if the options expires in the money or out of the money. When you correctly anticipate the trend of an underlying asset within the allotted time, the option is said to "expire in the money". When you incorrectly anticipate the trend of an underlying asset, the option is said to "expire out of the money".

The simple proposition is the root of the option's success. At its core, you are answering a yes or no question. Will the price of an underlying asset go up or down within an allotted amount of time?

How do I trade binary options?

Below you'll find an easy example of how to trade binary options:

After analyzing a specific asset, oil for example, you believe the price of oil will be above $45 within an allotted time frame. Of course, your understanding is based on a thorough analysis of the price of oil. If you think the price of oil will go up, you purchase a CALL option. If you think the price of oil will go down, you buy a PUT option.

If we take this example one step further and say you decide to purchase a CALL option for the price of oil according to your analysis that the price will rise within the allotted time. If you are right when time is up and the price of oil is $46, your option expired in the money!

The Binary Options Universe: Regulations, Financial News, and Trading Strategies

As with any financial instrument, you should never invest your money unless you can be sure the broker your are using is closely regulated - binary options is no different, and that's a good thing. After all, good regulations exist to maintain consumer confidence in a particular financial system, ensure stability, protect consumer, and limit financial crime. Of course the emphasis on each of the above components varies from jurisdiction to jurisdiction. Almost every country as their own regulatory authority which monitors local markets. For example, the US has the Securities and Exchange Commission as well as the Commodities Future Trading Commission. Canada meanwhile doesn't have a federal regulatory body. Each province has provincial regulatory authority.

Most of the major binary options brokers are regulated by the Cyprus Securities and Exchange Commission (CySEC) located in Cyprus - an EU member state.

After having registered with a regulated broker, the next step is to brush up on your understanding of global markets. It may sound daunting but it is really not. Most of us follow the markets on a cursory level already. There are a lot of great informational sites that give a bit more in-depth look at what's happening. You can find basic fundamental news e.g. how will a British exit from the EU affect currency trading? or you can find more technical trade analysis involving a variety of trading strategies that interpret fundamental news and market data to make CALL or PUT moves.

Two widely used strategies are "The Bandit Strategy" and "The Big Ben Strategy". The bandit strategy is wonderful for anticipate volatility in or to move ahead of the market. The strategy employees bollinger bands to estimate if an asset is at the moment overbought or oversold according to its current price against past price trends. Bollinger bands display standard deviations of an asset price's moving average (usually 20 day moving average) vs. the current price. With this strategy, you need to wait for the right moment when the price of the asset approaches the 3rd standard deviation. It doesn't happen often but with the right timing, you can take advantage of fast moving market volatility.

The big ben strategy is great for trading the GBP/USD currency pair. Part of the beauty of this strategy is its simplicity. Essentially, you look at a naked a chart and mark resistance or support lines. If the price trends breaks the line on a downward or upward trend, you purchase the corresponding option.

Binary Options vs. Forex?

Many people ask me: "If I'm already trading Forex, why should I bother with Binary Options?" That's an interesting outlook, but extremely limiting. Binary options allows for trades on major international stocks, indexes, and commodities, as well as currency pairs. You can quadruple your portfolio just by making the switch. You don't even need to sacrifice currency pairs as almost all the major binary platforms allow you to trade the most traded currencies. Any smart investor knows that diversification is the key to success. With binary options your trading options are much larger, which allows you to mitigate tough losses in one market with gains in any of the other three.

Am I gambling or trading with Binary Options?

Many people associate trading binary options with online gambling. This association is made mainly because of the short expiration time - which can be as short as 60 seconds. The argument is that this time interval is too short to gain an understanding of how the market will move, so at the end of the day any CALL or PUT option is based on a gut feeling. There are, however, differences from gambling. A trader can track the market and use strategies such as the above mentioned ones to gain a better understanding of how the market will move. The most important thing to understand when putting your money down on the table is what are potential rewards against the risks regardless if it is gambling, vanilla options, or binary options.