Binary options are fairly new to the speculation/trading landscape. They are called binary options as there can only be two possible outcomes. There are two types. Either cash-or-nothing binary options or asset-or-nothing binary options. They are binary in that you get all or nothing. They are also called all-or-nothing options, digital options (more common in forex/interest rate markets), and Fixed Return Options (FROs) (on the AMEX). Binary options are usually European-style options.
There are two ways of going with this as well. There is exchange traded binary options such as offered on the NADEX and there is non-exchange traded options. Each are structured differently. With exchange traded binaries, there is a set strike price. With most non-exchange traded binary options, you set the strike price upon entry. Your strike is your entry in the trade. It then expires in or out of the money. Structure of payouts are also different. Both Amex and CBOE listed options have values between $0 and $1, with a multiplier of 100, and tick size of $0.01, and are cash settled. In 2009 Nadex, the North American Derivatives Exchange, launched and now offers a suite of binary options vehicles. Nadex binary options are available on a range Stock Index Futures, Spot Forex, Commodity Futures, and Economic Events.
Thus far, personally, I have not spent anytime at all with exchange traded binary options. That will come in the future as I have been spending time with non-exchange traded binary options. These only recently became available to traders in the United States.
Non-exchanged traded binaries are mostly offered through brokers located in the EU. At first, I saw a lot of red flags and proceeded with caution. I choose one broker to begin with who had relatively good ratings by customers. GlobalOption is located in Nicosia, Cyprus. I had visions of Russian and Albanian mobsters running money through them. Indeed, they clear with a bank out of Bulgaria! Other red flags: they give you "bonus" money to trade. For example. Open with USD 550 and they will give you an additional $250 to trade. To "earn" the "bonus" money, you will need to trade the entire amount by 5 times or $800 X 5=$4,000 in total trading volume. Easy to open an account on line with your credit/debit card. How you withdraw: they will put back on your card any amount that you charged to your card only. After that, withdrawals are done by wire or check. I have already had the money put back on the card and have had no problem with wires from them as well. So, thus far, this broker checks out. Here is a link to them and I have no affiliation with them other than as a customer. http://www.globaloption.com It should also be noted that since Cyprus is part of the EU, they come under the jurisdiction of the EU's equivalent of the SEC.
Here is how these work. You can choose the amount you wish to trade. The minimum per trade is $25. Maximum trade in a single vehicle in one direction is $3,000. The maximum you can have on all trades at any given time is $12,000. You can choose an hourly expiration, end of day expiration or end of week expiration. You can trade indexes, some futures and single stocks as well. They have around 65 different vehicles available. You chose either put or call. Your entry is your strike price. At expiration you are either in the money and get paid or out of the money and not get paid. The amount of the payout will vary by instrument but you will know what that is before you enter a trade. As an example, typical payout on the SPX (S&P 500 cash index) is 78%. On the DJIA cash index it is normally 72%. In addition, they kick you back 10% of your trade amount on losing trades. As an example: you choose to trade the SPX at 11:35 am for a 12 noon expiration for $25 with a call. You enter the trade with a strike of 1315.56. At expiration (top of the hour) if cash settlement price is above 1315.56, you will receive $45 (your $25 capital in the trade+$20 in winning payout). Should the cash price be below 1315.56, you will receive $3 on your losing trade. Should settlement be at your strike (rare, only happened to me once) it is a "push" and your trade capital at risk is returned to you. With this type of binary, there is NO early exit. Once in the trade, you are in until expiration. Also, there is a lock-out period of 5 minutes before expiration. You can enter a trade at any time up to then. End of day is a 10 minute lock out as they settle 5 minutes after the close to allow for run-off after the cash close.
With this type of payout structure, with a 78% payout and 10% kickback on losing trades, you will need to be correct or have a minimum positive expectancy on your trades above 55% to make money. Some will use this vehicle as a gambling instrument. Please refrain from doing that as you will lose your money. Whatever gives you a positive expectancy in your trading can be applied to this to great effect. I have over an 80% win rate doing this now for over 2 months. I will give you just a couple of things that I do with this. One of which is actually a big hole in the "system" that you can drive a Mack truck through!
Here is something I back tested from 2005 forward. It is a Friday ONLY trade close to the market close. It is back tested on the DJIA cash index only at this time. I demonstrated this trade live here on the Slope after 3 pm Friday, May 25, 2012 if you would care to take a look. Here is the set up. At 3:15 pm you enter a call on the DJIA. Should the cash price be below your 3:15 pm entry at 3:30 pm, you enter another call at that time for equal money as your 3:15 pm call. This setup has a 74% positive expectancy.
This second is a real doozy and happens rarely. I do not know if they will "plug" this hole or not. What you do is after the close on either a Wednesday or a Thursday (not before!) IF there is a very large move in price during GLOBEX while the cash market is closed, go to the weekly expiration and enter your trade! The strike is the previous cash close!!!! This happened once with a very large drop in the ES. I loaded up the maximum ($3,000) on the SPX put for a close at the end of the week! This happened early on a Thursday morning!! As close to a sure thing as it gets!
In conclusion: if you are a day trader and have a solid methodology for very short term time frame expectancies, you may wish to look at this vehicle for additional profits. If that is not the case, please do not touch these with anything shorter than a 10 foot pole or your worst enemy's money! I hope this helps.
Yours in the never ending search for trading edges, The Market Sniper