Now that we have a basic idea on how binary option trades work, let’s take a look at a simple example.
Let’s say, you decide to trade EUR/USD with the assumption that price will rise.The pair’s current price is 1.3000, and you believe that after one hour, EUR/USD will be higher than that level.
You then look at your trading platform and see that the broker’s payout is 79% on a one hour option contract with a target strike of 1.3000.
After much deliberation, you finally decide to buy a “call” (or “up”) option and risk a $100.00 premium.
You could say it’s similar to going “long” on EUR/USD on the spot forex market.
|ENDING SCENARIOS AFTER ENTERING A CALL OPTION||GAIN/LOSS|
|Expiry price is above the strike price|
|$100.00 x 79% = $79|
$100.00 + $79.00 = $179.00
You gain $179.00 on your account.
|Expiry price is equal to or below the strike price|
|You lose your stake and your account declines by $100.00.|
As you can see from the calculations above, the risk you take is limited to the premium paid on the option.You cannot lose more than your stake. Unlike in spot forex trading, where your losses can get bigger the further the trade goes against you (which is why using stops are crucial), the risk in binary options trading is absolutely limited.
Payouts in Binary Options
Now that we’ve looked at the mechanics of a simple binary trade, we think it’s high time for you to learn how payouts are calculated.
More often than not, the payout will be determined by the size of your capital at risk per trade, whether you’re in- or out-of-the-money when the trade is closed, the type of option trade, and your broker’s commission rate.
In the example given above, you bet $100 that EUR/USD will close above 1.3000 after an hour with your broker offering a 79% payout rate. Let’s say that your analysis was spot on and your trade ends up being in-the-money. You would then get a payout of $179.
$100 (your initial investment) + $79 (79% of your initial capital) = $179
Easy peasy, right? Don’t get too excited just yet! You should know that there’s no one-size-fits-all formula for calculating payouts. There are a few other factors that affect them.
Factors in Payout Calculations
Each broker has its own payout rate. For starters, Forex Ninja’s intel shows that most brokers offer somewhere between 70% and 75% for the most basic option plays while there are those who offer as low at 65%.
Various factors come into play when determining the percentage payout.
The underlying asset traded and the time to expiration are a couple of big components to the equation.Normally, a market that is relatively less volatile and an expiration time that is longer usually means a lower percentage payout.
Next, the broker’s “commission” is also factored into the payout rate. After all, brokers are providing a service for you, the trader, to play out your ideas in the market so they should be compensated for it.
The commission rate does vary widely among brokers, but since there are so many binary options brokers out there (and more coming along), the rates should become increasingly competitive over time.
When a Binary Option Trade is Closed
As mentioned before, binary options are typically “all-or-nothing” trading instruments in that the payout or loss is only given at contract expiration, but there are a few brokers that allow you to close a binary option trade ahead of expiration.
This usually depends on the type of option, and usually it’s only available within a certain timeframe (e.g., available 5 minutes after an option trade opens, up until 5 minutes before an option expiration).The trade-off for this flexible feature is that brokers who do allow early trade closure tend to have lower payout rates.
When trading with a binary option broker that allows early closure of an option trade, the value of the option tends to move along with the value of the underlying asset.
For example, with a “put” (or “down”) option play, the value of the option contract increases as the market moves below the target (strike) price.
This means that, depending on how far it has moved passed the strike, the closing value of the option may be more than the risk premium paid (but never greater than the agreed maximum payout).
Conversely, if the underlying market moved higher, further out-of-the-money, the value of the option contract decreases and the option buyer would be returned much less than the premium paid if he/she closed early.
Of course, in both cases, the broker commission is factored into the payout of an option trade when closed early.
So before you decide to jump head first into trading binary options, make sure you do your research and find out what your broker’s payout rates and conditions are!