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Binary Option Basics – A Game Of Options

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Introduction

 

 

I am sure a lot of you are completely aware of what binary options are and what they have to offer the investor involved. However, binary options, like most derivatives tended to be “traded” by day-traders and portfolio managers alike due to their level of advancement that requires a more keen eye to study, analyze, and interpret price action while using various trading strategies – in addition to a more “avant-guard” approach in terms of fundamental and technical analysis.

But don’t get frightened, binary options are not as scary as most people may make it out to be – but this type of asset should be traded if you have a soundproof plan in place about how to invest in options. It all boils down to two things: if you are look for quick recurring profits every week or month (the short-term trader) or for small gradual growth and diversification for your overall portfolio as a means to earn extra income and minimize risk (the long-term investor).

Investing in binary options is a game – a game of options to be exact, and in this module, we will be going over the binary options basics, how they work, the types of options you can invest in, their risk-to-reward potential, and some of the more advanced and popular option strategies that are used by traders and investors alike.

Whether you are looking to become a full-fledged day trader, are looking to generate extra income, or are curious as to know what these assets have to offer, we at Invest In Wall Street has you covered.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Binary Options Basics: A Game Of Options

 

Option trading is an alternative way for investors to invest in the performance of a security, such as a stock or an ETF.

By trading options, an investor attempts to capture the up or down movement of a security while only investing only a fraction of the cost it would take to own the actual security.

For example, consider a stock that’s currently trading at $100. If you purchased a share and the price went up $5 dollars, you would have a 5% return.

With the right option contract, you could profit from this same jump in the stock price while only paying a small premium that costs significantly less than the price of owning the stock.

The ability to make more with less is one of the benefits of options trading. However, the potential for greater profits comes with greater risk of losses.

To help you understand why, lets take a closer look at how an option contract works.

 

The Inner Workings Of An Options Contract

 

 

Unlike a stock, when you buy an option contract, you’re not purchasing the security itself. Instead, you’re purchasing a contract that gives you the right to buy or sell a security at a certain price before a certain date.

Consider this example.

Suppose there’s a coffee shop chain called Stone Curb coffee. Stone Curb stock is currently trading at $50 a share.

An investor believes that the stock price of Stone Curb will rise. This investor considers taking advantage of this anticipated price  movement by buying 100 shares of the stock, but she is concerned about the initial capital requirement.

Now lets assume that there is another investor. He already owns 100 shares of Stone Curb stock and plans to hold onto it for a while. He thinks that the stock price will not increase much over the next few months.

 

 

Both investors can utilize a call option. This type of option contract gives the buyer the right to buy shares of Stone Curb stock at a set price, called a strike price, at a set time, called expiration.

In this case, its $55 per share (the strike) in four weeks time (expiration).

Typically, each standard option contract represents 100 shares. So this one contract would give the buyer the right to buy 100 shares of Stone Curb stock at $55 per share.

The buyer purchases the contract by paying the option’s premium.

The premium, or price of the option, is determined by several factors, including the stock price, time until expiration, and implied volatility, which is how much the stock is expected to move during the life of the contract.

This premium gets credited to the seller of the call option and helps to partially offset the original purchase price of the stock.

For this example, lets assume the total premium is $100. Our buyer pays the $100 and purchases the contract. Now
lets examine what could happen to this investment.

Let The Game Of Options Commence!

 

 

Suppose our buyer’s instincts were right, and Stone Curb stock is now selling at $60 per share. Remember, the call option gives the buyer the right to purchase shares of this stock for $55 a share.

The buyer could exercise the call and purchase 100 shares for $55 each, and then sell them at market value for $60 each, making a profit of $5 per share, not including commissions.

Because shares of Stone Curb have risen by $5, the buyer’s contract is essentially worth $500.

If our buyer sold her contract, she could potentially make around $400 in profit, the value of her contract minus the $100 premium she originally paid for it, as well as any commissions and fees.

While the buyer’s investment paid off, things didn’t work out as well for the seller.

Although he was able to collect $100 for selling the option, he missed out on a portion of the stock’s appreciation because he was obligated to sell his stock at $55 per share.

 

 

Now let’s rewind.

Suppose the stock moved in the opposite direction and is now selling for $45 a share on the last trading day prior to expiration.

The buyer’s contract gives her the right to purchase shares of Stone Curb for $55 a share.

Because no one would want to pay $55 for a stock that’s selling at $45 in the open market, the buyer’s contract will likely expire worthless. The buyer is now on track to lose 100% of her initial $100 investment, plus any trading commissions and fees.

 

 

For the seller, the option expiring worthless is good news. He still owns his shares of stock and made $100 selling the option.

Although the value of his shares declined, he was able to keep the option premium less any commissions and fees for selling the option.

 

 

Keep in mind that this is a simplified example. The pricing of options is very complex, which is why its important to educate yourself about options and their risks before you invest.

While the biggest change comes from the price of the underlying instrument that the contract represents, there are other forces like time decay and implied volatility that influence options prices.

While we showed you one example, options can be used in a variety of ways.

There are call options, which we just saw, that can be profitable to own if the price of a stock goes up – and then there are put options, which can be profitable to own if the price of a stock goes down.

Calls and puts can also be combined in a variety of ways. By buying and selling these options, investors have the potential to make money when the market moves in any direction and create strategies with a variety of risk levels.

 

 

You’ve taken the first step in understanding options. Check out more of our binary options education here at Invest In Wall Street.

 

Quick Recap

In Review….

Binary Options Basics

 

  • Option trading is an alternative way for investors to invest in the performance of a security, such as a stock or an ETF
  • By trading options, an investor attempts to capture the up or down movement of a security while only investing only a fraction of the cost it would take to own the actual security
  • With the right option contract, you could profit from this same jump in the stock price while only paying a small premium that costs significantly less than the price of owning the stock
  • The ability to make more with less is one of the benefits of options trading. However, the potential for greater profits comes with greater risk of losses
  • While the biggest change comes from the price of the underlying instrument that the contract represents, there are other forces like time decay and implied volatility that influence options prices
  • There are call options, which we just saw, that can be profitable to own if the price of a stock goes up – and then there are put options, which can be profitable to own if the price of a stock goes down
  • Calls and puts can also be combined in a variety of ways. By buying and selling these options, investors have the potential to make money when the market moves in any direction and create strategies with a variety of risk levels

 

 

The Anatomy Of An Option Contract

 

  • Unlike a stock, when you buy an option contract, you’re not purchasing the security itself. Instead, you’re purchasing a contract that gives you the right to buy or sell a security at a certain price before a certain date
  • Call Options – This type of option contract gives the buyer the right to buy shares of stock at a set price, called a strike price, at a set time, called expiration
  • Typically, each standard option contract represents 100 shares
  • The buyer purchases the contract by paying the option’s premium
  • The premium, or price of the option, is determined by several factors, including the stock price, time until expiration, and implied volatility, which is how much the stock is expected to move during the life of the contract
  • This premium gets credited to the seller of the call option and helps to partially offset the original purchase price of the stock

 

 

And this is essentially the key concepts of binary options trading. If you have read from previous investing modules here at Invest In Wall Street, you would have noticed that binary options is a member of the derivative asset class – a type of investment whose price is dependent on another asset.

Options may be attractive to some investors due to the low capital requirements and for the possibility of high returns (ROI) – but it should be noted that with a greater risk, options can come at a cost if you miss an opportunity and lose a trade.

When investing in options, you are buying a legally binding contract that may allow you to buy or sell the equivalent of 100 shares of stock. This contract sets a predetermined price to buy/sell at, the strike price – in which the contract, or offer, will expire at a future date, which is when the contract is “expired”.

Investors and traders can use options to their advantage if they predict the anticipation of a large price move or if they think that the stock may take a dive. There are 2 types of option contract that you can make, known as call options or sell options, and 4 basic option choices that you can make: if you’re bullish, you can either buy a call or sell a put – and if your bearish, you can either buy a put or sell a call. The only difference is if you are on the offense (the buyer) or on the defense (the seller).

For buyers, you will have to pay a premium to the seller (known as “debit”) and will only be able to get it back if the price is above the strike at expiration for call options or below the strike for put options – otherwise, the seller will hold the premium and you lose your initial investment.

For sellers, you will receive a premium from the buyer (known as “credit”) and will only be able to hold on to it if the price is below the strike for call options or above the strike for put options – otherwise, you will have to hand back the premium to the buyer. As you can tell, trading options is an “all or nothing” enterprise where you “go big or go home”.

Most investors and traders execute options using various strategies, such as vertical spreads, iron condors, butterflies, strangles, straddles, ect. – all of which consist of a series of buying/selling calls/puts in order to minimize risk while maximizing their profit potential.

This type of trading will most likely be conducted by professional investors, hedge fund managers, or even day-traders – who are able to use their experience and expertise to pull off trades to this magnitude. Actively trading options, or derivatives for that manner contains more risk.

Remember to not trade using any strategy that you are unfamiliar with and understand the amount of risk you are taking on before entering any trade.

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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