Well, if you’re on this page, then you must know what binary options trading is all about. If you’re ready to make a trade but don’t know how it works, then you’re in the right place. We are going to break down the schematics of trading binary options with a neat example.
How Trading Binary Options Works
For the purpose of this example, we have decided to assume that the price of the currency pair EUR/USD will rise.
Current price for the pair: 1.3000
Your prediction: Price for EUR/USD will rise
Payout Rate: 75%
After much consideration, you put in a $100 premium on the trade. You can check out different options trading strategies here.
Gain/Loss Scenario: You gain$75 on your invested $100 if you predict right. Therefore you’ll have $175 in your account. You lose your stake; yes, you lose every single penny of the $100 you ‘invested’. It might seem a bad thing to lose your stake, but the losses are bearable compared to that of spot forex trading. In forex trading, your losses could get very big and accumulate into the next trade (this is why traders make use of stops when trading forex). In Binary options trade, the risk is limited.
After examining the rudiments of a simple binary options trade, it’s only fair that we break down the calculation of payouts. In binary options trading, payouts determine the amount of capital put under risk in every trade. It also determines when your trade closes, the type of option and the commission rate for your broker.
We’ve already explained in the example above, the simple mathematical calculation of payouts on option trades. If you’re confused as to how we calculated the payout, it goes thus:
Your initial investment + % of your initial stake = Balance in options trading account. The minimum deposit on option trading accounts is normally pretty high.
It’s pretty straightforward when you think about it. But keep in mind, there are factors that influence the percentage of payouts.
Factors Influencing Payout Package
Every binary option trading firm has its payout rate. The percentage ranges from 70% to 80%; while some offer payout rates as low as 65%. You can read more about the regulation standards here. What causes this difference in payout rates? Well, that depends on a couple of factors like:
- Underlying Asset and Time of Expiration: Naturally, the type of the asset being traded plays a big role in payout rates. An asset, like stocks, traded in a very volatile market translates to a higher payout rate because the risk is more. Also, time of expiration affects payout rate, in the sense that a longer expiration time means lower payout rate due to risk being low. The reverse is true for both factors.
- Broker’s Commission: Brokers have to eat, don’t they? Underlying asset and expiration time aside, the broker’s commission plays the biggest role in payout rates. Brokers establish a platform for you, the trader, to make predictions on the market. For doing so, they earn commission rates which varies according to the broker. Due to a high number of binary option brokers out there in the market, payout rates are bound to be competitive. Also keep in mind that when you lose a trade, your broker eats up your stake. One of the best and most safe choices when deciding between different brokers is IQ Option. IQ Option is one of the most legit binary option brokers with low commission rates and is regulated by some of the most strict regulators in the industry. You can find the review article about IQ Option here.
Closing a Binary Options Trade
If you don’t know by now, binary option trades are basically an all-or-nothing operation. There are no buy or sell stops. Profits (payouts) or losses are only received when the contract expires. However, there are some brokers which allow traders to close their binary option trade before the time of expiration.
Early closing of a binary option trade depends largely on the type of option purchased. The timeframe for closing is very small, usually within 5 minutes after a trade opens and 5 minutes before the option expires. Brokers who allow early closing of binary option trade usually give lower payout rates. In this case, the value of the option trade moves in conjunction with the value of the underlying financial asset. That is to say, an option contract increases in value as the market heads towards a price lower than the target price.
In the first scenario, if the market moves lower than the target price (strike), the option’s closing value will exceed the risk premium paid—but never more than the maximum payout.
The second scenario; if the market moves higher than the target price, the option contract decreases in value and a lesser amount of premium will be returned if the buyer closes early. In both scenarios, the broker’s commission weighs in heavily on the payout of the option trade.
Before taking up a binary option trade, make proper research on the broker’s commissions and payout rates. You can find more information about binary options here. If you are just starting out we would highly recommend you to start with low amounts or even chose a managed account option where a professional trader trades on your behalf.