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What Are Binary Options? PA R T I Introduction to Binary Options his section will provide you with an overview and discussion of the T main benefi ts of binary option trading. What You Will Learn: • What are binary options? • How do binary options differ from traditional options? • Which underlying instruments are binary options available to trade on? • Where can youhttp://www.pbookshop.com trade binary options? • What are the benefi ts of trading binary options? • What makes binary options unique compared to other instruments and options? COPYRIGHTED MATERIAL When you complete this section you should have a basic understand- ing of what binary options are and be familiar with their main advantages. 1 c01.indd 1 11/8/2012 4:12:44 PM http://www.pbookshop.com c01.indd 2 11/8/2012 4:12:44 PM CH A P T E R 1 What Are Binary Options? inary options are also known as digital options or all‐or‐nothing options. They are derivative instruments that can be considered a B yes‐or‐no proposition—either the event happens or it does not. Binary options are considered binary because there are only two po- tential outcomes at expiration: 0 or 100; 0 and 100 refer to the settlement value of a binary option and could be viewed in dollars. At expiration, if you are incorrect, you do not make anything ($0), and if you are correct, you make up to $100. The next section will go into further detail on the set- tlement value of binary options. ON WHAT ASSEThttp://www.pbookshop.com CLASSES ARE BINARY OPTIONS AVAILABLE? Binary options are available on four different asset classes. These include stock index futures, commodity futures, spot forex, and economic data re- leases. This section will explain the basics of what each of the asset classes are and how they work. Before we explain the different futures asset classes, it is important to fi rst understand what futures are. A future is a contract that says that the buyer or seller will purchase or sell a specifi c asset for a specifi c price at a specifi c time in the future. Investors trade futures contracts to speculate for profi t and to hedge their assets. One of the benefi ts of trading futures is that traders don’t have to physically buy a certain commodity in order to 3 c01.indd 3 11/8/2012 4:12:44 PM 4 BINARY OPTIONS speculate on its price movements. They can simply enter their trade with a smaller amount of cash on margin. Futures contracts are traded on an exchange, and their price typically moves with the price of the underlying asset. Since traders are speculat- ing on a future price of an asset, the futures price can be slightly higher or lower than the spot price. All futures contracts have specific expiration dates that vary by the as- set class on which the futures contract is based. Let’s look at an example of speculating with futures contracts: Let’s say the price of physical gold is currently $1000 per oz. and you believe the price is going to increase. Instead of buying physical gold, you can buy gold futures on margin for $1050 per oz. Let’s as- sume that after one month physical gold has gone up to $1200 per oz. and gold futures contracts are trading at $1210. You can exit your posi- tion and lock in a profit of $160. This profit is calculated by subtract- ing the futures purchase price from the futures sale ($1210 per oz.) or $1210 – $1050 = $160. For a trader, using futures on margin is a lot more convenient than actually buying and holding physical goods. To see real time futures quotes, simply visit www.traderschoiceoptions .net. Stock Index Futures Stock index futures are futures contracts based on a variety of global and domestic stock indexes. They can be used to speculate on the price direc- tion of a stock market index, or hedge (protect) against a sudden price decrease of a portfolio of stocks. Traders use futures to speculate on stock indexes so that they don’t have to buy or sell every single stock in an index. Futures allow traders to buy an entire indexhttp://www.pbookshop.com on margin, which is much more convenient. Stock index futures contracts are traded only for a certain period of time, typically one quarter of the calendar year. This means that the price of a futures contract is good only until the expiration date, on which the particular futures contract can no longer be traded. Let’s take a look at a binary option trade on a stock index future: Let’s say that Standard & Poor’s (S&P) futures are currently trading at 1000 and you think that the S&P futures are going to decline to 995 later today. You can sell one daily US 500 (S&P 500) binary options contract with a strike price of 1000 that will expire at the end of the day. With this binary option an assumption is made that at the end of the day the futures price will be below 1000. At the end of the day the S&P 500 futures are trading at 990 and your binary options contract has expired. Because you were c01.indd 4 11/8/2012 4:12:44 PM What Are Binary Options? 5 correct in your assumption, your binary option contract yields a profit. The mechanics of binary options contracts will be covered in subsequent sec- tions of this guide. Binary options are available on the following stock index futures: • Wall Street 30 (Dow Futures). Futures based on the Dow Jones Industrial Average (DJIA). The DJIA is a stock index of the 30 largest publicly traded stocks on the New York Stock Exchange (NYSE). • US 500 (S&P 500 futures). Futures based on the S&P 500, an index made up of 500 large publicly traded companies that trade on either the NYSE or the Nasdaq. • US Tech 100 (Nasdaq Futures). Futures based on the Nasdaq 100 index. The Nasdaq 100 is an index composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. The Nasdaq is a stock exchange that is traditionally where many high‐ tech stocks are traded. • US SmallCap 2000 (Russell 2000 futures). Futures based on the Russell 2000 index. The Russell 2000 is an index measuring the per- formance of 2,000 “small‐cap” publicly traded companies. Small‐cap refers to the number of outstanding (owned) shares of a company, and in this case the companies are small. • FTSE (Liffe FTSE 100 futures). Futures based on the FTSE 100 index. The FTSE 100 index is an index of blue‐chip (large companies) stocks on the London Stock Exchange. • Germany 30 (Eurex Dax futures). Futures based on the DAX 30 index. The DAX 30 is an index of the 30 largest German companies traded on the Frankfurt Stock Exchange. • Japan 225 (Nikkei 225 futures). Futures based on the Nikkei 225 index. The Nikkei 225 index is made up of Japan’s top 225 companies on the Tokyohttp://www.pbookshop.com Stock Exchange. • Korea 200 (KOSPI 200 futures). Futures based on the KOSPI 200 index, which is made up of the 200 largest companies on the Korean Exchange. Commodity Futures Commodities are physical goods, such as oil, corn, or gold. Commodity futures are a financial instrument that can be used to speculate or hedge on various physical commodities. Commodity futures are usually priced slightly higher than the spot commodity in order to account for the convenience that the futures offer to the trader. Commodity futures are exchange traded and typically change along with the price of the underlying. c01.indd 5 11/8/2012 4:12:44 PM 6 BINARY OPTIONS Let’s take a look at a binary option trade on a commodity future: Let’s say that gold futures are currently trading at $1000 per oz. and you think the gold futures are going to reach $1100 later today. You can buy one daily gold binary option contract with a strike price of 1100. With this binary option an assumption is made that at the end of the day the futures price will be above 1100. At the end of the day the gold futures are trading at 1100 and your binary options contract yields a profit. Binary options are available on the following commodity futures: • Crude oil futures. Futures contracts based on current price if you were to buy or sell physical crude oil. Crude oil is the commodity that is used to produce heating oil and gasoline. Crude oil futures have contracts that expire each calendar month. • Natural gas futures. Futures contracts based on the current price if you were to buy or sell actual natural gas. Natural gas is used to heat homes. Natural gas futures have contracts that expire each calendar month. • Gold futures. Futures contracts based on the current price if you were to buy or sell physical gold. Physical gold is used to make jewelry and is also used in manufacturing. Gold futures have contracts that expire in February, April, June, August, and December. • Silver futures. Futures contracts based on current price if you were to buy or sell physical silver. Physical silver is used to make jewelry and is also used in manufacturing. Silver futures have contracts that expire in March, May, July, September, and December. • Copper futures. Futures contracts based on the current price if you were to buy or sell physical copper.
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