Those who are new to trading may be confused by the difference between options and binary options. One should never start trading without first educating themselves about the subject. One should fully understand the advantages of vanilla options vs binary options before they begin making even small trades.
Options depend on predictions about future prices
Both ordinary options and binary options are predictions about the value of a stock in the future. To succeed at trading options, one must be able to predict the price of a commodity in the future accurately. If one can predict that the cost of oil, for example, is going to be higher at a set point in the future, than they may buy options in oil. If the price of oil increases, the value of their option will increase as well. If the price of oil falls, their option will reduce in value.
How typical options contracts work
Trading options is not the same as typical trading of stocks or commodities. One can use options trading as a way of significantly limiting the amount of risk that they face. When trading stocks, one could buy 1000 shares in a company for $12 each. If the shares were to become worthless, the investor would lose as much as $12000. If one trades options, they can limit their risk.
Options are split into call options and put options. The former allows the trader to buy the stock at a fixed price at a future date. The latter allows the trader to sell the stock at a fixed price. If an investor believes that shares in a company are going to increase in value from $12 to $15, they could purchase a call option that allows them to buy shares for $13 in six months. If the shares turn out to be worth $15 in six months, they will be able to buy shares worth $15 for only $13.
One of the best things about buying options is that one is not under any obligation to buy shares in the future. If the price of each share increases to as much as $50, one would still have the legal right to buy shares for $13. If the price of each share were to decrease to $5, one could choose not to buy any shares at that price.
Of course, there is still some rather than no risk involved. The risk in buying call options is a premium or fee that one must pay for the contract. The premium for a contract to buy 1000 shares at $13 in six months might cost $1000. If the price of the shares increases to only $13.50, the option holder loses $500 as they do not earn enough to cover the cost of the premium. On the plus side, it is not possible to lose more than $1000 if one purchases a typical options contract for $1000. Risk is minimal compared to futures trading and ordinary investing. If the shares, unfortunately, turn out to drop to only $1 in six months, an options investor only loses $1000. A futures investor that is obligated to buy shares for $13 in six months would lose more than $10000.
Options vs binary options: How much risk is involved?
If ordinary options limit an investor’s risk, is this also true for binary options? Binary options are very different than digital options. An investor will often use binary options to increase rather than reduce the risk they face, and to make high-risk investments in low-risk markets.
When investing in binary options, the amount that the stock changes in price does not matter. An investor might predict that the price of oil will be slightly higher than it is now in a few days. They could then purchase binary options that depend on a slight oil price increase for $65 each. If the price of oil increases slightly in the next few days, their binary options will sell for $100, and they will make a $35 profit for each option they purchased. If the price of oil is even slightly lower than predicted, however, than their binary options become worth $0 and they take a $65 loss for each option they purchased. Again, it does not matter how much the price of oil or any other commodity or stock changes. A large amount of money can be won or lost with binary options depending on how well an investor can predict even small price changes.
Binary options are therefore very different from vanilla options. When purchasing binary options, an investor is looking for risk and not trying to minimize it. The price does not have to crash for the investor to lose a lot of money; it only has to decrease a very little. On the plus side, binary options allow one to make a lot of money off of a slight price increase. Neither ordinary investing nor ordinary options allow an investor to make much money off of small price increases.
How are options and binary options different from futures contracts?
With a futures contract, one is obligated to buy or sell at a future date. One cannot choose not to buy or sell when the contract expires, as is the case with options. If one buys a futures contract to buy shares at $20 in a few months, they are obligated to buy the shares even if the price decreases to $5. A futures contract is, therefore, riskier than an options contract. With a futures contract, you can lose a lot more money than the price of the premium.
Compared to binary options, on the other hand, futures contracts are not very dangerous. Making a wrong prediction and purchasing a money-losing futures contract is not likely to result in one losing most or all of their money. Losing most or all of your money is a worst-case scenario with futures contracts. With binary options, on the other hand, any wrong prediction always results in losing all of your money.
Should a new investor choose options, binary options, or futures contracts?
Futures contracts tend to be too large for newer investors. They are sold mostly to wealthy professional investors. With binary options or with vanilla options, one can find much smaller contracts. Whether to go with binary options or with vanilla options depends on your risk tolerance. Binary options are always dangerous; vanilla options are less severe. Binary options also tend to depend on much shorter-term predictions than ordinary options. One might consider binary options if they believe they are capable of making short term predictions much better than the typical investor. As well as considering the riskiness of options vs binary options, a new investor should always experiment with a practice account before investing any real money on the stock market.