Binary Options Hedge vs Trading Barrier Options

Are Barrier Options the Right Choice for You?

Before one considers trading barrier options one should also consider the similar alternative investment, the binary options hedge. Although the investments are very similar in terms of in the money yields offered, the risk characteristics are considerably different. Many times the determining factor in deciding which asset to trade comes down to a choice of convenience versus control.

"The development of binary options trading has been a huge blessing for the world of hedge trading for retail investors," said Steve Wise of binary-option-broker.com. "It affords the retail trader the opportunity to make simple hedges in the marketplace as a means to trade for profit or as insurance against loss. Previously this sort of risk management trading was the realm of institutions and wealth managers."

Convenience vs Control

Wise added that when it comes to picking barrier options or attempting to use the binary options hedge it really came down to a choice of convenience or control. "Does the retail trader want to buy a spread of values outright with barrier options or does the trader want to have more control over when - and whether - an individual binary options contract is left open or hedged. The effort required to do either trade and the range of potential outcomes is considerably different depending on which contract you decide to use."

When a trader picks up a binary options contract with the intent to potential hedge the initial contract with an equal and opposite trade, the resulting combination of assets provides a small range of strike prices with a high yield of sixty to eighty percent and a very wide range of values with a modest loss - "Typically ten percent plus or minus," according to Wise. In theory the draw of opening one contract and then hedging it revolves around having the opportunity to create a window of values with a high yield while all other possibilities preserve most of the capital invested.

Boutique Solution vs Off-the-Shelf

On the other hand in the case of barrier options the retail trader effectively walks up to the counter and picks up whatever spread of values is offered by the barrier options broker. Said Wise, "The range of in the money expiration prices is set by the broker at purchase and the day trader then hopes the contract expires with the spot price somewhere in that money range." Once the contract is purchased, the trader effectively walks away having already bought both the put and calls at the same time. One major difference with the binary options hedge is that the tail risk - the possibility that the contract expires outside the money - results in loss of most or all of the investment. "In theory the tail risk is the price the trader pays for the typically wider spreads and convenience of buying a range of values with no initial open ended exposure," said Wise.

Regardless of whether a trader has an interest in barrier options or binary options it behooves them to take a basic options trading course to learn the ropes according to Wise.

Online Options Trading Basics

Here are a few online options trading basics anyone interested in trying to make money by investing in stock options. We'll try to cover anything and everything we can think of from deciding where to open an account to what to expect from your first trade. It is my hope by the end of this you have a good idea what trading options is about and have the confidence and knowledge you need to make your first trade intelligently.

Online Options Trading Basics: What Is Option Trading?

Option trading is the process of buying and owning the right to buy (or sell) shares of stocks, commodities, or other assets. When one buys an options contract, they own the right to purchase some other asset on or before a future date for a set price. Think of it as being similar to (but not exactly the same as) putting a purchase on layaway (a washing machine, for example) at the local department store. At any time in the future up to "X" number of days before the layaway expires you can walk in and pay for your washing machine at the price you locked in when you put it on layaway. Options work nearly identically.

The principal difference between the washing machine example above and an options contract is that the cost of the option is completely separate from the purchase price of the underlying asset. In most layaway contracts, the deposit made on a washing machine is credited toward the final purchase price. Not so in options.

The other significant difference between options trading and a layaway contract is that you, as the trader, can either BUY or SELL the RIGHT to BUY or SELL assets. In a layaway contract, you're only in the position of BUYING assets. The point is there is quite a bit more complexity in options trading than buying something on layaway... but the layaway example is useful in describing what options trading represents conceptually.

What Matters in Trading Options Online?

There are very few differences between online options trading brokers these days. The principal differences between brokers will be cost per transaction (trade) and variety of other services offered. Odds are if you are engaging in option trading online your focus should be cost, which will be lower at specialist options trading companies such as optionsxpress. Specialist houses can offer lower costs because they don't have the high overhead associated with other more service intensive products like retirement planning, IRAs, 401Ks, and the like. If you are options trading online for income, cost needs to be your principal focus. End of story. Fill out the online screens to setup your username, password, and your account basics. Print out forms for margin accounts and electronic banking, as well as any forms which require a returned signature.

What to Expect When Opening an Account

Expect to have to fill out a lot of forms / or at least read a lot of forms online (at least 2 forms will require printout and signature for options trading typically). I strongly urge you to printout and READ the forms you are signing. Reading the fine print will help you understand some of the risks associated with options trading, and it will also clarify your rights as an account-holder - yes, you have rights which brokers must disclose to you.

The two forms you should expect to print and sign are the account signup form, and the margin account agreement. A margin account is required to trade options, as you will be in position (potentially) to be buying shares for which you do not have the cash to purchase outright. You don't have to understand this entirely right now (you can see an example of the risks of leverage here if you're so inclined). READ THE MARGIN AGREEMENT! It contains important language about restrictions and how the broker will operate when things go wrong (as they potentially can).

Beyond Opening the Account: Funding

Above and beyond opening an online options trading account you'll need to fund it. Nearly all account funding these days is done electronically. Be prepared to submit a blank voided check with your account application. This will allow funds to be transferred between your bank account and brokerage account - a MUST in today's fast paced world of online finance. The other ways to move funds in and out are with a credit card (not everyone does this), and or a paypal account (which can link to your banking account as an intermediary). The best setup is to simply have your local bank electronically tied to your brokerage account. There is a form for this as well (what else is new). Print it, sign it, and attach a blank voided check to it. Send it in. Once done and all the account information is verified you'll be prepared to move funds in and out of your account quickly and cheaply - critical to keeping liquidity high and costs low in your trading account.

Preparing to Make Your First Trades

Once you have your account setup (which requires an awful lot of work just to setup) and funded, you are ready to make trades. All you have to do now is figure out which trades to make. Fear not, we've written a primer - an options trading tutorial for you to take it from here.