In the financial world, binary options are a type of options wherein the payout is either a fixed amount of some underlying asset or it is nothing at all. Binary options are of two main types. They are the cash-or-nothing and asset-or-nothing options. Whereas a fixed amount of cash is paid for a successful outcome in the case of cash-or-nothing options, the value of an underlying security is paid in the case of asset-or-nothing options. As the possible outcome of binary options trading is limited to two (a yes/no proposition), these options are binary in nature and are known by different names such as digital options in forex/interest rate markets, all-or-nothing options and fixed return options on the Amex. In general, these options are referred to as European-style options.
The best thing about binary options trading is that you will know for certain as to what return you can potentially make even before purchasing the options. It is possible to buy binary options virtually on all financial products in both directions depending on whether you anticipate the price of the underlying asset to increase or decrease. The expiration period of a binary option contract may range from one minute (60 seconds) to one hour or a day or even a week. Binary Options that are cash-settled are European-style options, meaning options can be exercised only at the end of the expiration period.
Binary Options Can Have Only Two Outcomes
Binary Options Trading
As mentioned earlier, you need to predict the price direction of an underlying asset when trading binary options. However, the trading is facilitated by binary options brokers who provide the platform. Within most platforms, you can make the prediction by selecting either the Call or Put button. Whereas the Call option predicts an increase in the price of the underlying asset, the Put option predicts a decline in price. You are not required to predict the magnitude of the movement as in the case of vanilla or traditional options. You are required to only correctly predict whether the selected asset’s price will be lower or higher than the specified price of the asset.
Here is an example to illustrate the outcomes in a binary trade:
Assume that you are trading in cash-or-nothing type binary options and you have purchased a Call option on ABC Company’s stock which is trading at $100. The payout for in-the-money trade indicated by the broker is 80 percent. The expiration time of the contract is one hour.
At time of expiration of the contract (that is after one hour), if the stock trades either at or above $100, you will receive a payout of $190. On the other hand, if the stock trades below $100, you get nothing. However, some brokers pay back of $10 to $15 (10 percent to 15 percent of your investment).
Non exchange-traded Binary Options
The binary options trading platforms offered by binary options brokers came into existence by the middle of 2008. They offer simplified versions of exchange-traded binary options. More than one hundred such platforms are in operation, offering options on hundreds of underlying assets. These platforms make available standardized binary options with short expiration periods. You cannot liquidate the options before expiry, unless the broker allows you to do that.
These binary options trading platforms offer underlying assets from the four different asset classes – commodities, stocks, indices and currencies – for binary trades. They also provide several types of trades with short expiration periods so that you can choose those that suit your trading style best and maximize your profits.
Exchange-traded Binary Options
In the U.S., the Securities and Exchange Commission approved the listing of cash-or-nothing binary options in 2008 after the Options Clearing Corporation proposed certain rule changes a year before. In the same year, the American Stock Exchange (Amex) and and the Chicago Board Options Exchange (CBOE) introduced exchange-traded European style cash-or-nothing binary options.
Amex makes available binary options trading on a few Exchange-traded Funds and highly liquid stocks like Citigroup and Google. They refer these options as Fixed Return Options. CBOE makes available binary options on indices: the CBOE Volatility Index and S&P 500. CBOE only offers Call options. The values of options, offered by both CBOE and Amex, range from $0 to $1 with 100 as a multiplier. The tick size is $0.01. The options are all cash settled. The Nadex, which came into the binary options space in 2009, offers options on a wide range of assets from forex, commodities and indices.
Binary Options Vs. Traditional Options
Before you embark on a trading career in the binary options market, it is important that you have a clear understanding of the difference between the binary options and standard vanilla options. The extent of reward you can get or the loss you have to suffer when you win or lose an option contract is by far the biggest differentiating factor.
In the case of binary options, the profit you make or the loss you incur is actually a fixed amount. The binary options broker with whom you are associated specifies the profit you can make if your prediction is right and the loss you can incur (limited to your investment) if your prediction happens to be wrong even before you purchase the option. This is to say that you can experience is a great deal of certainty when dealing with binary options.
In the case of vanilla options, there is no limit on the amount of profits you can earn or losses you can incur. This makes trading in vanilla or traditional options a very risky affair. Therefore, investors who have limited capability to take risks and those with lower risk appetite will find it more comfortable to trade binary options.
Summarizing, binary options trading has gained a great deal of popularity among investors ever since it was launched in 2008 because of its predictability. In addition, they are easy to understand and extremely simple to trade when compared with the trading of standard vanilla options.
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Disclaimer: “Your capital may be at risk. This material is not investment advice.”