Binary Options Guide: Key Concepts for Beginners
Entering the world of binary options can be a daunting experience for beginners. Everywhere you turn there’s a new word, such as "spot price" or "out of the money" for you to get your head around. You might think that you need to be a stock market trader in order to understand the world of binary options. Not true! In this instalment of our Binary Options Guide, we’ll break the binary options world into its key components and explain how each part works. By the time you’ve finished reading, you’ll feel more prepared to tackle the diverse and fast-paced world of binary options trading.
You may already know what binary options are, especially if you've read our introductory article. But here's a reminder. With every binary options trade, you're trying to predict what will happen to the price of an asset (e.g. gold or shares in a company) within a given time frame.
Binary options are usually framed in terms of a question with a yes or no answer. For instance, will the Tesco share price rise within the next 15 minutes? There are two possibilities - yes or no. If your choice turns out to be correct, you'll win a predetermined return. If you're wrong, you'll lose what you staked. The word trade is used very loosely in the binary options world. People talk about trading binary options, purchasing binary options and betting on binary options. You can use whichever phrase you prefer. They all relate to the same question - what's going to happen to the price of an asset in the future?
To trade or gamble with binary options, you’re going to need an online broker. Binary options brokers provide an electronic platform for betting/trading to take place. Examples include:
A binary broker is a bit like a bookmaker; however, instead of offering bets and odds related to horses, they offer bets and odds related to the prices of assets. Each broker uses trading software that automatically churns out data related to particular bets, such as a bet's "return", "profit" and "price". The figures quoted by brokers are constantly changing and being re-calculated by their software, as the price of each asset moves. We'll discuss what these figures mean later.
Some brokers request that you download their trading software to make trades, whereas others will allow you to use it from their website. Signing up for an account with a broker is usually free and straightforward. Some will allow you to open demo accounts, which enable you to practice trading with pretend money. We'll explain how to set up a demo account in a future article, so look out for that.
Deposit with Ukash and Skrill at Binary.com Once you're ready to trade with real money, there are a variety of depositing options to choose from. Binary.com, for instance, offers 19 methods, including our casino favourites - Ukash and Skrill. If you browse various binary brokers, you’ll see that the binary options look different depending on the software they use. To make matter worse, terminology varies between brokers. But don’t let this put you off. While the words and appearances may vary, the key elements remain the same. Once you’ve got to grips with a binary options trade at one broker, you should be able to deal with them all.
What Does a Binary Option Look Like?
In Figure 1 (below) you’ll see a screenshot of a binary options trade from Binary.com, with key features labelled. Binary.com is a well respected broker that's regulated by the UK gambling commission, and has been around for 15 years. It was first established under the name BetOnMarkets.com in 2000. We'll be referring back to this screenshot, throughout the article.
As you can see at the top left of the image, Rise/Fall is selected. Rise/Fall is the most common type of binary option and is also known as the High/Low option or Up/Down option. It involves answering the question - will the price of this asset be higher or lower than its current price, after a specified period of time (e.g. 15 minutes)? We'll discuss other types of binary option in a future article: Types of Trade.
An asset is simply a resource of economic value. Examples of assets include: gold, oil, shares in a company and currency pairs. The asset shown in Figure 1 is the currency pair - EUR/USD. To read more about assets, look out for our future article: What are Assets?
Graph showing price movement over time for Eur/USD[/caption] The Spot Price is the current price of your chosen asset. Spot Prices are constantly changing, and trying to predict what this price will be in the future is what binary options betting is all about.
Price of the Option
Once you've chosen which option you want to purchase (or which bet you want to place) you pay the price of the option to your broker. The price of the Rise option, in Figure 1, is quoted as £57.76, and the price of the Fall option is £64.15. As you'll see, when we discuss probability later in the article, the price of the option is directly related to the probability of the option being successful. The price you pay for the option will be your maximum potential loss for your bet. In other words, if your bet is unsuccessful, you won’t lose any more than the sum you paid for the option. With some brokers, you may receive a small refund, if your bet is unsuccessful. So, it's not necessarily an all-or-nothing situation. For instance, at AnyOption.com, you’ll receive a refund of between 5 - 25 % of the price of your option, if you lose.
Bet in time frames of 10 seconds to 365 days at Binary.com Time is a key concept in binary options trading, as when you're trying to predict whether an asset’s price will rise or fall, it’s always with respect to a particular time frame. At Binary.com you’ll be allowed to chose the start and end of your time frame. (Most other binary brokers will only let you chose the end time). The time-frame could be anything between 10 seconds and 365 days. Being able to choose the start of your bet is a very useful function as it can allow you to take advantage of influential events in the wider world. For instance, if you know that a successful technology manufacturer is due to release a new product tomorrow afternoon, you might choose to bet on the share price of that manufacturer rising tomorrow afternoon.
Entry Spot/Exit Spot
To determine whether your bet has been successful, the spot price at the start of your time window - which is sometimes called the entry spot - will be compared with the spot price at the end of the time window - which is sometimes called the exit spot. For instance, suppose we purchased the Rise option for EUR/USD, and we chose to frame our bet from now until 15 minutes in the future - which is what we’ve selected in Figure 1. For our Rise option bet to be successful, the exit spot would have to be higher than the entry spot in 15 minutes time. If we selected the Fall option, to be successful our exit spot would have to be lower than our entry spot in 15 minutes time.
In the Money/Out of the Money/At the Money
If your bet is successful it’s sometimes described as being in the money. When your bet is unsuccessful, you’re out of the money.
There’s a 3rd possibility. What happens if the exit spot is exactly the same as the entry spot? Brokers sometimes describe this situation as being at the money. Brokers will have a particular policy that they’ll refer to if you end up “at the money”. Make sure you check what your broker’s policy is for “at the money” options before placing a bet.
Early Exit and Extension
Certain brokers - including binary.com - allow early exits. An early exit is when you exit your bet before your pre-specified time for a reduced percentage return. This is a useful option if you find that the market has taken a sudden turn for the worse, and you want to lower your chances of finishing “out of the money”. Some brokers - such as Banc de Binary - allow trades (or bets) to be extended. At Banc de Binary you can do this up until 10 minutes before expiry. This function is useful if the price of your asset is moving slower than you thought it would, and you want a bit more time to see if it will make a profit.
Payout and Profit
You need to select your payout - this is the amount of money you'll recieve if you win. In Figure 1, we've selected a payout of £100. Payouts could range from £1 to £100 000, depending on the broker. Your payout includes the price of the option, and you can work out the profit you’ll make by subtracting the price of the option from your total payout. Take a look at the blackboard below to see how the profit is calculated for bets related to the Rise and Fall options.
Odds and Probability
When you calculate the odds and probability of some event taking place, you’re using two instruments that gauge how likely it is that an event is going to happen. Knowing this information will help you assess the level of risk associated with placing certain bets. In this section, we'll show you that...
- The price of the option is directly related to the probability that the bet will be successful
- The percentage return is directly related to the odds that it will be successful
Odds are calculated by comparing the number of undesirable outcomes with the number of desirable outcomes. For example, let’s suppose you wanted to work out the odds of throwing a six on your next dice roll. We know that there’s 1 desirable outcome (rolling a 6) and 5 undesirable ones (rolling a 1, rolling a 2 and so on). We would express the odds of rolling a six as 6/1. In gambling, you can use odds to calculate what your profit will be, as odds tell you how much money you can make from a stake of 1 unit. Suppose you want to bet on a horse with odds of 3/1. These odds tell you that, if your bet is successful, for every unit you stake, that unit will be multiplied by 3.
What are the odds for our binary bets? Let’s consider the Rise option first. We know what our profit for this bet would be £42.24. We also know that the number of desirable outcomes is 1 (that the price will rise). But we don’t how this compares to the number of undesirable outcomes, which we’ll represent as x.
rSimply convert the figure of 0.73 to a percentage (multiply by 100) to arrive at the figure of your return: 73%. You can see that the return directly reflects the odds (see Figure 1). While we’re at it, let’s work out the odds for the Fall bet too. We know that the price of the option is £64.15 and that the profit will be £35.85. When it comes to the odds, we know that there’s one desired outcome (that the price falls), but how many undesirable outcomes are there (x)?
When you convert 0.56 to a percentage (i.e. multiply by 100) you get 56% which is the figure that is quoted as your return (see Figure 1).
Calculating Probability From Odds
Probability is similar to odds in that it’s another way of measuring the likelihood of an event taking place. However, instead of simply comparing the number of undesirable outcomes with the number of desirable outcomes, you’ll be comparing the number of desirable outcomes with the sum of all possible outcomes. This sounds confusing, but don’t worry. You’ll see what we mean in a moment. Here’s the sum we use to calculate probability using odds:
To calculate the ‘sum of all possible outcomes’ simply add the ‘number of desired outcomes’ (1) to the ‘number of undesired outcomes’ (0.73). You’ll see that we’ve done this in the blackboard below:
So, the Rise Option has a 57.80% chance of coming off. As you can see this figure directly reflects the price of the option, which is £57.76 (see Figure 1). Don’t worry about the fact that there’s a 0.04 difference between the two figures. Binary.com have simply rounded their figure up. What about the Fall Option?
The possibility of the Fall option being successful is 64.10%, which is directly related to the price of the option: £64.15 (see Figure 1). There’s a 0.05 difference between these figures which is related to rounding. The results of our calculations tell us that the Fall option is somewhat more likely to be successful than the Rise option. But there's not a huge difference - only 6.39%. To use a horse-racing analogy, there isn't a clear favourite between these two options. To make a more informed decision, we'd need to do a bit more research into the asset we're betting on. Look out for our articles on Technical Analysis and Fundamental Analysis in which we’ll show you the tools you can use to research an asset’s price movement.
In conclusion, by grasping key concepts such as "spot price", "profit", "return", "odds" and "probability", you’ll be in a much better position to trade wisely. Remember, however, that understanding the figures quoted by binary brokers is not the whole story. Consider horse racing. Some people make decisions about which horse to bet on simply by looking at the odds. But experienced horse race gamblers take other things into account, such as the track record of each horse, and the weather on the day of the race. You can do the same thing with binary options. Stay tuned and we'll show you how!