When we place a derivatives trade, we are of course counting on the price rising substantially within a certain period of time. In the world of binary options, this is the key principle behind maintaining a secure and profitable position. However, there is much more to these mechanics than simply “predicting” that the price of a certain position will remain bullish into the near future. Thus, it is important to understand the definition of what is known as an underlying asset. Let us take a look at this concept a bit further to appreciate the importance of this metric.
Underlying assets explained:
Let us imagine that you are new to the markets and you wish to employ the use of a professional binary options trader. It will be his or her job to make sure that within a certain period of time, your option will increase in value to a specific level. For instance, let’s say that you are looking to place yourself into a binary trade involving currencies. More specifically, perhaps your broker believes that the price of the dollar will substantially rise. Thus, the underlying asset, in this case, will obviously be the value of the dollar. Or, you may instead wish to pick up a gold option. In this instance, the underlying asset that will determine a profit or loss will be the price of spot gold. You could also venture into the world of electronics and pick up an option on a major computer manufacturer. The underlying asset would be the stock of the company. So, the definition of this term closely mirrors the term itself. It is for this reason that any movement of a certain option will be derived from the value of the correlated underlying asset; hence the phrase derivative that is often used.
Binary Options Asset Definition
Assets in binary options are valuable holdings on which the entire trade is based. As a trader, you need to analyze the fluctuating asset value and place your bet accordingly. If you have correctly predicted the price of an asset, you will make a profit. Otherwise, you will lose the trading amount.
Financial news like reports of companies and market changes generally swings the value of an asset in a given time.
Types of underlying assets
Underlying assets in binary options trading are of four different types, i.e., stocks, currency, commodity, and bonds. Each of these assets has its pros and cons.
Additionally, they have their potential risks. So, it becomes essential for an investor to understand each type of underlying asset inside out to get a clear understanding of what they can expect when trading in them.
Popular Binary Options trading assets
Every binary options broker does not offer similar assets. However, the assets mentioned below are the popular ones in options trading.
Currency pairs like USD/EUR, USD/JPY, EUR/GBP, and USD/GBP are commonly traded in binary options. This is because to trade in currency; you need to speculate whether the price of one currency will be more than the other one or not.
With binary options, you can trade on the stocks of different companies like Apple, Coca-Cola, Google, and more. You can also invest in local stocks depending on the broker you are trading with.
You can enter the binary options trading world by investing in commodities like silver, oil, or gold. Commodity trading is a low-risk investing method and can diversify the overall risk.
With indices, you can invest in larger markets like DAX, FTSE, and S&P. By investing in indices, you can diversify the risk and make more profit.
Why underlying assets matters?
In binary options trading, underlying assets can help traders to understand and hedge risk.
Example of an underlying asset
Here’s a quick example to understand what an underlying asset is.
Let’s assume you are investing in the stocks of a company named X. You can purchase 200 stocks at $120. Here, the stocks of the company become the underlying asset.
When trading involves stocks, the stock of a particular company is the underlying asset. But in other cases, currencies also become underlying assets.
Choosing the right asset
Each of these assets has its pros and cons. But you can minimize the possibility of risk by choosing an asset that you are familiar with.
Whichever asset you choose, keep yourself acquainted with its financial trends and price fluctuations.
How does an underlying asset affect a Binary trade?
This is a critical question to address, for understanding the relationship between the two can allow you to make sound judgment calls. In fact, this is a very important part of literally any well-rounded trading strategy. As you are likely aware, the premise behind a binary option (not to oversimplify) is that you will be paid out with s fixed amount of a specific asset or you will receive nothing whatsoever at the close of the trade; thus the “binary” nature of the trade. So, it is obviously important to be aware as to whether the value of an underlying asset behind a certain option is expected to remain bullish.
In other words, you are hoping that the asset (and therefore your position) will become more valuable. Again, we should return to the instance of a binary option in gold. As we have seen, the value of the underlying asset, in this case, will be the price of spot gold sometime in the future. More discretely, perhaps you have taken stance on your binary trade that is known as a “cash-or-nothing” position. You hope that your option will expire in profit. So, what needs to be addressed? In the instance of gold, the spot price will determine whether or not you will be “in the money” upon the completion of your trade. So, there will naturally be several factors to take into account. The value of gold will be affected by fluctuations in the price of the dollar.
The demand will also play a naturally important role. Also, any market volatility may cause the value of spot gold to traditionally rise as investors look for a safe haven during times of perceived turmoil. These are three examples of the different metrics that can affect the value of an underlying asset (and therefore, your position in a binary trade itself). A simpler instance can be seen in the aforementioned binary trade of the stock of a certain computer company. If there are rumors that this company is soon to release a new piece of software or that even the stock itself will float on a major exchange, it is likely that the value of the underlying asset will increase (at least in a short-term perspective). So, entering into a binary trade before such movements take place will be an excellent way to make certain that you are “in the money” upon the expiry of your option.
These are what are known as some examples of binary signals that should be addressed. Of course, such a strategy takes a great deal of time to develop and even the most astute binary options traders will not always be correct one hundred percent of the time. So, the theory is to mitigate the risk of an underlying asset dropping in value as opposed to eliminating this risk entirely. So, these are some of the main principles to keep in mind when entering into a binary trade. These are also the same reasons why many traders will make use of a dedicated broker in order to execute a trade. These brokers are highly knowledgeable and will follow all of the most important signals and market trends as they occur. In this manner, the advice that they give will be much more likely to produce a positive result. For a further understanding of this term, there are a number of well-written binary options books available to help sharpen your skills while placing you into a profitable and rewarding position.
Investing in a familiar asset can protect you from major trading losses. To choose the right asset, you can practice on a demo account. This will help you understand the limitations and benefits of investing in a particular asset.
Image Credit: BankofEngland
See other important articles in my glossary.
(Risk warning: You capital can be at risk)