As discussed in “Binary Options: An All or Nothing Gamble?” binary options are a way of trading options for securities, commodities, and foreign exchange based on correctly predicting their future value against the current price. A “call” (buy) option assumes the price will rise. A “put“(sell) option is based on predictions that the price will be lower. Traders have no claim to the underlying asset on which the option is based.
Binary options have polarized the investment community and many of those against it base their opinions on the bad publicity generated by fly-by-night online brokers that promise too much and deliver too little. But what of legitimate binary option trading offered by top 10 binary options brokers or in government-approved exchanges such as the NADEX (North American Derivatives Exchange). Is there a way for the ordinary investor to play the game and win?
Binary options only involve two outcomes. Either the price is higher or lower when the contract expires and based on that you either win or lose. But even when you enter a contract based on pure guesswork the odds are not the same as a coin flip. This is because, right from the start, you stand to lose more than you gain. For example, finishing “in-the-money” (your higher/lower guess is correct) might guarantee a return of 81% but finishing out-of-the money means you lose 100%. Some contracts do offer to return part of your investment, but it’s usually not more than 5% or greater than the difference between 100% and the percentage of the payout.
This is how shady brokers make money, even when they don’t charge commissions for the trade. They’re essentially betting against you. The math for this is quite involved, but the average returns will always be negative for the investor. For the example cited above (81% vs. 5%), you will need to win 55.8% of the time to just break even.
The odds discussed above are done on the assumption that your trades are independent of each other. But what if you actually had a strategy and based your decisions on an overall assessment of the big picture? The Martingale strategy is premised on holding your position, no matter how bad, because the situation will turn sooner or later. The rise (or fall) in the prices of stocks, forex or commodities can’t go on indefinitely without a downturn (or rebound). There has to be a ceiling or floor somewhere and it’s always been proven that every new piece of information influencing the market helps the market it correct itself.
The problem with the Martingale strategy is that you need to have deep pockets to stake out a position until you recoup your losses. Here’s why. If you lose on a trade, you will need to assume the same position (either put or call) on the next trade but this time you will need to increase your investment so that when you do win, you’ll cover the loss and make a small profit in the process. The problem with this is that until you do win, the subsequent investment necessary tends to multiply exponentially. Starting with $5 that pays out %81, for example, will require you to invest $10 in the next, $20 in the third, $50 in the fourth, and so on.
It’s no surprise that Martingale is a betting strategy that traces its origins to gambling, and is one of the reasons why roulettes now have double zeros instead of just one so the outcome isn’t just binary and the chances of a Martingale strategy being profitable for the gambler in the long run is eliminated. For single zero roulettes, the house has an insurance policy – table limits. Even if you had the money to go on betting until you won, table limits will cap the amount that you can bet. Some online brokers of binary options trading do this too, but they hide it in the fine print. Many online brokers don’t allow you to invest more than $1000 on a contract. Unwary investors do this and find out later, to their dismay, that they can’t withdraw the payout because they violated a stipulation of the contract.
So, the Martingale strategy isn’t for you and you want something you have more control over? You want to leverage knowledge to make more informed decisions about your trades? You want to actually understand the underlying assets that binary options contracts are based on?
Welcome to the real world. If you want to play it right, you need to invest time in learning the ins and outs of the financial market for options. No free lunches here, unless you want to give online brokers their free meals by investing on the basis of pure luck. There are ways to tilt the odds in your favor.
Here’s a list of the things you need to study. You’ll need to wrap your head around these concepts if you’re serious about binary options. Your task is easier than the trader of plain vanilla options because you only need to guess higher or lower to finish in-the-money, but still you need to be right more than you’re wrong to get your investment back. Each of these concepts involve tools (which we won’t discuss in detail here) that might give you brain freeze. Don’t say we didn’t warn you.
Judging movement. You can use tools to assess market breadth, which is an assessment of the declines and advances of a market over time. Breadth indicators aggregate statistics on the number and volume of declining and advancing issues (stocks, commodities or currencies), new highs and lows for specific issues, and issues trading below or above the average. Common tools used include the New York Stock Exchange’s (NYSE) advance-decline breadth indicator, and the Arm’s Index or the Trader’s Short-Term Index (TRIN).
Analyzing sentiment. Sentiment is usually reflected in either bullish (buying calls, selling puts) and bearish (buying puts, selling calls) behavior. Crowds aren’t always the best place to look for wisdom, but you can plot your moves based on how the crowd behaves. Monitoring put and call activity is one way to measure the behavior of the crowd. The put to call (P:C) ratio is simply derived by dividing put volume with call volume. Low ratios indicate a bearish market. People are wary, fearful, or pessimistic. High ratios indicate the bullish opposite. Optimism rules the day and people ride the wave until it breaks. All exchanges publish their version of the P:C ratio. Some measure only equity, others only indices, some focus only on retail activity. You’ll need to identify which ratio applies to the underlying asset that you’re trading binary options on.
Smelling fear. Markets generally fall faster than they rise because people tend to exit shaky situations faster than they’re willing to commit new money to potentially profitable positions. Volatility is a measure of fear and fear is one of the primal forces driving the market. Exchanges also publish a volatility index (VIX), a very important tool because the sale of options and their prices are driven by volatility.
The point being made here is straightforward. Trading in binary options takes skill and knowledge. It involves some amount of luck, but you can limit your exposure to risk if you know what you’re doing.
Binary options trading is all about managing risks and rewards. You’ll need to embrace this as a guiding principle and accept the fact that you can’t avoid losses but you’ll end up “in-the-money” if you planned well and have the patience to see your plan through. You’ll need to exercise discipline when trading, and have a tight leash on your greed and fear. You’ll also have to be in it for the right reason – not just to make a quick buck but because you love the game.
Sounds like it could apply to just about anything else in your life? You bet it does. Except that in trading binary options, these words to live by are not optional. You have to do them all and then some, if you don’t want to be parted with your money.
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