By Darrell Martin
Thinking of binary options as a ‘yes or no only’ proposition is the top mistake binary option traders make.
Binary options have become a hot new topic. Most often binary options are thought of as a simple yes or no contract. Either the market will or will not expire above or below a certain price at a certain time.
If you choose correctly, you get the maximum profit payout. If not, you lose your investment.
So if this is what a binary contract is, then what’s the mistake?
Let’s look at three examples:
If a trader trades call or put options, whether it be strangles, butterflies, verticals, diagonals, calendars, or just plain vanilla calls and puts, most would agree that it is unwise to hold the trade to expiration.
Likewise, in futures contracts, traders do not buy or sell the future and hold onto it until the last trade date, and rarely ever until the delivery date.
A stock trader does not buy a stock and wait to cash it in until a company does a stock buyback program.
Related: 5 Common Misconceptions Regarding Binary Options
Why do stock traders, future traders, and option traders close their positions early? There are a multitude of reasons such as:
Limiting the loss
Locking in a profit
Account size and margin issues
To relieve capital and move on to the next trade
The list can go on and on…
So why wouldn’t a binary option trader consistently close trades before expiration?
- They incorrectly believe that binaries where meant to be held until you can’t hold it any longer.
This is no more true for a binary than any other financial instrument, option, future, stock or otherwise. Maybe they believe this as they have only seen bucket shop binaries or someone told them this is how they work. In any case, they are misinformed.
- They do not know that a binary option contract can be closed early, as they have not traded on Nadex.
To be fair, many people are not aware that you can close a binary trade early. Although this is not the case with binaries everywhere, on the Nadex exchange, all contracts can be closed before expiration to limit losses or lock in profits. This can help a trader trade more advanced strategies and help keep a profitable trade from becoming a losing trade.
- They are greedy and want maximum profit.
Traders will buy at $10 and see a binary go up to $95 (maximum value $100) and they want that last $5. Maybe they will get it. If not, it turns around and goes back to $0 and they just gave up an $85 profit. And if they do get the final $5 in profit, do they consider the cost? They could have closed the trade and opened a couple of additional contracts with the freed up capital instead of waiting for that small $5 profit.
- They have not been taught effective take profit methods.
For example, a binary contract on Nadex will be priced at $50 (give or take a few dollars in bid/ask spread) when its strike is at the same price as the underlying market. So a trader can buy a low risk binary for about $20 risk, targeting a price level and exit when it hits it for about $50 per binary option.
Or a trader may choose a higher probability binary option with a risk of $70, (think deep out of the money credit spreads) with a maximum profit of $30. If it moves up to $95, they take a $25 profit.
They don’t risk the market retracing and losing the profit and possibly a lot more. Or, they exit the trade if the market hits the strike at $50 and take a small $20 loss on the trade.
- They do not understand that a binary option is delta.
It is representative of probability at expiration. So, if you buy a binary at $70 time and time again and hold until expiration, you should make $30 70% of the time and lose $70 30% of the time, resulting in a break even (less fees) result. Basically, a trader who does this is an inexperienced trader and though they may have some good fortune, the probabilities will catch up and wipe out all the profits eventually.
Exit before Expiration
In summary, if you are trading binary options, learn to take profits before expiration. Know at what price you will be taking profit and at what price you will be exiting to limit losses, when applicable.
Though all losses on binary option contracts are limited, there is no need to take the maximum loss on a binary option trade any more than there is on any regular option trade.
Don’t lose the common sense that you apply to other trading instruments when it comes to having an exit versus a buy and hope plan. And you will be on the road to trading binary options more effectively.