The Risk and Reward Profile of Binary Options

In this lesson
  • What is meant by “limited risk”?
  • The full value of a binary option
  • Collateral requirements when placing a trade

Limited risk means my risk is limited. Right?

Okay, yes. But there’s more to this simple term. And it’s a big reason binary options are so powerful.

Limited-risk means that you know your maximum risk on every trade before you enter the position. You can never lose more on a trade than what you paid to enter it.

As you know from the previous course, a binary option can never go below zero or above 100, no matter what happens in the underlying market the binary is based on. Even if the market has another "Flash Crash," your binary option won’t. It might go to zero, but it won’t go negative.

The limited risk profile also means your profit is capped at a maximum. If the underlying market makes a big move in your favor, your binary will go to 100 and no further. Some traders trade such large moves with a series of binary options at different strike prices, dividing the move into several pieces, each with limited risk. And many traders like having a defined profit target. Successful traders always have an exit strategy.

A better way to limit risk than stop-loss orders

If you’ve traded leveraged markets like futures or forex, you've seen the risk disclaimer that states “you may lose more than your original investment.” Your reaction may be, “That can’t happen to me, I use stops to manage my risk.”

Unfortunately, the history of trading is littered with the busted accounts of traders who traded the old-fashioned way, only to have one surprising event drain their account and even leave them owing more money.

The risk profile of binary options may be the best thing about them. Not every trade will be successful, but with Nadex you are guaranteed that you get to decide your worst-case scenario before you place the trade.

Because your risk is automatically capped, you don’t need or use stop-loss orders to protect your trade from losses. You can, however, get out early with a smaller-than-maximum loss.

If you’ve ever been stopped out by a quick market move, only to watch the market turn back in your direction, you understand the risk of using stops. A binary option, by contrast, might go to zero value, but you won’t be stopped out of the trade. If and when the market turns back around, you’ll still be able to profit. You have essentially bought time to be right.

Total Contract Value and Collateralization

Let’s now take a look at the monetary value of a binary option. All Nadex binary options, regardless of the underlying market, have the following characteristics:

  • The price range is from 0 to 100 points
  • Each point is worth $1.00
  • Total contract value is $100.00
  • The buyer’s maximum risk is the buy price minus the floor of zero
  • The seller’s maximum risk is the ceiling of 100 minus the price you paid to sell.
  • The buyer's collateral plus the seller's collateral always equals $100.00

Example

Let’s look at an example. Say you wanted to buy a US 500 binary option at 27. Your order ticket would look like this:

Your worst-case scenario (the red part of the bar on the left) for this trade is if it settles at zero. Your order ticket shows your maximum loss (27 points x $1.00 per point or $27.00) so you can know it before you place the order. Since Nadex doesn’t do leveraged trading, if you don’t have that $27 collateral in your account, the trade simply won’t go through. You will never get a margin call from Nadex.

For every buyer, there’s a seller. If you are selling a binary option priced at 27, your worst-case scenario (the red part of the bar on the right) is a settlement of 100. If you click Sell, your order ticket will show your maximum risk as 73 points (100 - 27) times $1.00 per point or $73.00. As a seller, you put up $73.00 in collateral to execute the trade. If you don't have $73 in your account, the trade won't go through. And $73 is all you can lose. 

Okay, I get the risk, but what about my reward?

The potential reward on any Nadex binary option trade is also a simple calculation. The green parts of the bars above show the reward side of the $100 dollar.

On the buy side, the best possible outcome is always 100. So the potential reward for a buyer is simply 100 minus the buy price. In this example that would be 100 – 27, or 73 points, which equals $73.00 (represented by green in the left graph above).

On the sell side, the best possible outcome is always 0. When a binary option expires worthless, the seller gets $100 minus the initial sell price. In this case, you paid $73 to be a seller, so your maximum reward would be 100 – 73 = $27. If risking 73 to make 27 seems like an odd choice, think of it this way: the price of $73 reflects a roughly 73% probability at the time you entered the trade that the binary would expire worthless. The odds were in your favor as a seller and that's why you paid more. 

Once you’ve trade binary options for a little while, this math will become second nature. But to make things easier and give you a way to double-check, we calculate your maximum loss and profit and put the live number at the bottom of your order ticket. Change your order price, and the profit and loss will automatically be updated.

These examples don’t include exchange fees, which would be $0.90 to enter the trade and, for trades that don’t expire at zero, $0.90 to exit. We don’t charge a closing fee for trades that expire worthless. For details of how fees are calculated, please see Nadex Exchange Fees.

 

At this point you should understand:
  • What is meant by limited risk
  • The total value of a binary option contract
  • How to figure out the maximum potential risk and reward for any binary option trade, whether buying or selling
  • If you are still not exactly sure how the risk/reward math works, you should at least know where to go to find this when placing a trade (HINT: It’s at the bottom of the order ticket)

 

Use these questions to test your understanding:

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