What are Binary Options?

Written by Saul Griffith

binary options explainedBinary options are a hot new way to trade the markets. Simple to understand and execute, they offer both newbie and advanced traders an opportunity to participate in the markets with controlled risk and in short time frames. 

Options 101

Binary options, at the risk of sounding simplistic, are a kind of option.
 
Let’s get down and dirty and look at the more inclusive regular class of options before we come to the specifics of binaries.
 
 An option is defined as a contract that gives the buyer of the option the right (but not the obligation), to buy or sell the underlying asset or instrument at an agreed strike price on or before a specified date, the expiry. It is a derivative instrument because it derives its value from that of underlying assets such as forex, commodities or stock indices. 
 
What is traded here is the right. Therefore, an option contract that gives the owner the right to buy the underlying asset at a specified price is called a Call option. On the other hand, a contract that endows the owner a right to sell the underlying is called a Put option. 
 
Like underlying assets, options too are traded on stock exchanges and are called Exchange Traded Options (ETO’s).
 
Like the underlying assets, options too move up or down in value. But they require much less capital to trade compared to buying or selling the underlying asset. Thus it might require @25,000 to buy 500 shares of Company "X" at its current price of $50 a share. On the other hand, the investor might do well to just buy the option contract that may be trading at say, $800 per contract. So, if he buys 5 call contracts, the investor has paid a premium of $800 x 5 = $4,000, giving him the opportunity to ride the upside in the stock at a much lower outlay. Much of the gains in the stock would transmit to the option contract, too. 
 
Net, net the trader could:
  1. Limit his loss to the maximum loss of premium,
  2. Trade without stress and
  3. Preserve his trading capital, by trading regular options.

Binary options

Binary options are a different kind of animal, though they similarly get their market value from the market value of the underlying assets. Like regular options, binaries too are based on assets such as forex, commodities and stock indices. 
 
They are called binary because a trader is required to make a very simple, yes/no judgment on the direction of the option – will it go up, or will it go down by the time it expires? (Binary = two digits, 0 or 1, to take a math example).
 
The trader gets a fixed amount if he calls the direction correctly; usually the amount paid for the option plus a profit percentage. However, if he is wrong, he loses the entire amount he paid for the option. In other words, it is either all or nothing.
 
This is how a binary options works:
 
  • Underlying asset: Gold
  • Current price: $1360
  • Amount to invest: Minimum (usually) $10, Maximum (could be as high as $10,000)
  • Expiry time: Varies between 60 seconds to weekly
 
So, if a trader feels that the price of gold could rise within the next hour, he would buy a ‘High’ binary option expiring at the hour. Assume that the binaries trading site is offering an 80% return on gold binaries.
 
At the end of the hour, on expiry, if gold ended higher than $1360, the trader was proved right in his judgment and the binary option worked out in his favor. He would get a total payoff of his initial amount of $10 + 80% return of $8 = $18. If, however, the price closed lower than $1360, the trader would get nothing and lose his investment of $10.

Binary options and regular options compared

The most important difference between binary and regular options is that in the former case the trader knows in advance his profit or loss on the binary transaction. That’s because the amount paid for the option, as well as the payoff on it, are fixed beforehand. This is not the case with regular options.
 
Again, regular options have much longer expiration times compared to binaries, ranging from weekly to even longer. In contrast, binaries come with very short expiries, even as low as a minute!
 
Lastly, unlike regular options, a trader can’t bail out of his binary option trade midstream, and is generally committed till expiry. However, certain binary brokers do offer a trade close out or a rollover of the binary options. But these come at expensive charges.

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