A binary option is a financial contract in which depending on whether the option expires in the money, the participants to the transaction are allocated one of two outcomes. The name "binary" refers to the fact that binary options depend on the result of a "yes" or "no" proposition. If the binary option expires in the money, traders are paid out, and if it does not, they lose money.
Understanding Binary Option
Binary options have expiration dates and times. To profit, the underlying asset's price must be on the right side of the strike price at expiration.
After the expiration of a binary option, the resulting profit or loss is immediately applied to the investor's account. This means that the buyer of a binary option will either get paid some fixed amount or lose their entire investment. As a counterbalance, the option seller might choose to keep the premium paid by the buyer or must pay the full amount.
A basic example of a binary option would be a bet on whether or not XYZ share price will be higher than $48 at 2:30pm on December 11, 2023. The trader then decides whether or not the price will be higher than $48 (yes), or lower than $48 (no) at that specific time and day.
Let's imagine the investor is willing to risk $1000 on the deal in the hopes that the price will be above $48 at the specified time and date. Shares of ABC will pay out according to the terms agreed upon if their price rises above $48 on that date. If the payoff percentage is 75%, for instance, the trader's binary options broker will deposit $750 into their account.
If the price is less than $48 at the time of the trade, the trader made the wrong bet and would lose the whole amount ($1000).
Choosing Between Binary and Conventional Options
The holder of a conventional option contract has the exclusive right to purchase or dispose of the underlying asset at the option's strike price until the option's expiration date. Conventional options, often referred to simply options, give the buyer the right, but not the obligation, to acquire the underlying asset. Traders who purchase these options assume a fixed risk, but their potential payout is proportional to the change in the value of the underlying asset.
Unlike traditional options, binary options don't allow the trader to actually buy the underlying asset. In the case of binary options, the maximum potential return is predetermined, while the highest possible loss is capped at the initial investment. The underlying asset's performance has no effect on the profit or loss realized.
Profit or loss is determined by whether the underlying asset price is above or below the strike price. The payment on some binary options might be reduced if they are closed before their expiration date, assuming that the option is in the money.
While conventional options are regulated by the Security and Exchange Commission (SEC) and traded on regulated U.S. exchanges, binary options are not.
Even though the SEC and other agencies do oversee some binary options trading platforms, the vast majority of binary options trading takes place outside the United States and may not be regulated. Unlike their licensed counterparts, unregulated binary options firms are not held to any minimum requirements. That's why it's important for anyone considering investing to keep an eye out for signs of fraud.
Example of Binary Options
In the United States, Nadex is a regulated binary options exchange. Nadex binary options are "yes" or "no" wagers, and traders can cash out at any time before the option expires.
All binary options have an expiration value of either $100 or $0. The entry price of the option reflects the possible gain or loss.
Let's say that Apple stock is $175.25 right now. A binary option with a $176 strike price and at 2pm tomorrow expiration time is available. For $30, the trader can purchase the binary option betting that it will be above $176 tomorrow at pm. If the stock price ends the day at $176 or above, at expiration the binary option will be worth $100. Assuming he or she invests $100 while risking $30, the trader will make a profit of $70.
The trader stands to lose $30 if the option expires while the price of Apple is less than $176 (out of the money). With Nadex binary options, the maximum gain or loss option is always $100.
One way to increase the size of an investment is to increase the number of option contracts being traded. Using the previous example, if you choose three contracts, your exposure will climb to $90, and your potential reward would rise to $210.
Non-Nadex binary options are very similar to Nadex binary options, with a few key differences: they are not regulated in the United States, you may not be able to trade in $100 increments, and the payout rate for winning trades is normally predetermined.