Investing in some situations can warrant use of serious money, like buying a blue-chip stock that will be held as part of the buy-and-hold portion of a portfolio. Other situations, however, are a bit nebulous, and although one might have a good feeling about how the stock might perform, it is still perhaps a riskier situation than others. To this point, there are an eclectic mix of derivatives designed to let investors hedge a position without owning the underlying equity. Two of the most popular alternatives are options and binary options.
Traditional options are often called “vanilla options,” and binary options are also known as digital options, fixed return options (FROs), or all-or-nothing options. Both of these options have differences and similarities. The prices of both are derived from the value of the underlying asset. Both also give the owner the right to buy or sell the underlying asset, at a specific price, on or before the expiration date. The underlying asset is simply a benchmark for the option itself, and it is used to determine whether the option has expired in or out of the money. Underlying assets include stocks, currencies, indices, bonds and commodities, and investors can get involved in hedging a position in any one of these assets at a greatly reduced cost over buying the asset outright.
We all invest to make money, and so understanding the payout structure of both is a necessary component to deciding what is best for you. With binary trading, the payout is predetermined at the outset of the contract being established, and payout, should it be in-the-money, will be between 50% to 90%.
With vanilla options, the payout will be variable, and it is determined by the stocks movement after the strike price is hit. What this means is that if you have a strike of $15, and the stock runs to $22, your payout will be the $7, on a call, upon trading of the contract. On a put, that same situation would be quite costly. With traditional options, buyers pay per contract, and their results will vary, but with binary options, the outcomes are fixed from the start, thus the name binary.
Risk V. Reward
There is a firm, UltraTrade, that provides a trading academy online. Any investor that is new to options should check out their site, and the training that is offered. There is a comprehensive area on trading binary options, and this will clear up most questions an investor might have. That said, once a better understanding is established, the payout structures will make more sense.
With binary options, an investor can never lose more than the original investment, and in some cases they might even be refunded up to 15% of the original contract investment amount, even if it finishes out-of-the-money. The profit for finishing in-the-money is less than that of traditional options, but the initial outlay is normally less as well. The important thing to remember is that binary options are a simple yes/no investment vehicle.
Vanilla options offer virtually unlimited upside, but the initial investment is generally higher, and the risk is greater. The reason there is more risk is because if you write calls, and the stock appreciates beyond the strike, the underlying shares have to be produced. This means the shares have to be purchased at market price. When options are written, the underlying asset is borrowed from accounts where the customers are holding the security on margin. Those shares, however, are not the ones that will be used to cover.
If the buyer of an option believes the stock will rise, they reserve the right to buy the stock at the lower price, and then sell it for a profit. Puts and calls can go either way, and in a volatile market, an investor should be working with an options trader they can trust, or they need to have a good command of options strategies themselves.
Overall, binary options cost less, provide a less expensive way to hedge swings, and provide a way for those with not much understanding of options to get familiar with this advantageous derivative.