We keep hearing about them all the time, but what the hell are binary options?
A binary option is an option that pays either a fixed amount or nothing, depending on whether a certain condition is fulfilled when the option expires.
Binary options are also referred to as all-or-nothing options, since it is a type of option where the payoff is all or nothing. The return is therefore fixed and it comes as no surprise that such options are also known as: FRO’s-Fixed Return Options. Digital options is also another commonly used term. More simply a trader just needs to make a decision about the direction of a rate change: whether the underlying asset’s price is going up or going down without taking other factors into consideration.
Binary options are considered as a mass market financial instrument as it empowers traders with a very flexible trading approach without the complexities involved in trading traditional vanilla options. Whether you are looking for a short term speculation or hedging your portfolio, binaries can help you get a high payout within short trading periods and as such are gaining global popularity among traders. Binary options are available on a variety of underlying assets: Stocks, Commodities, Currencies and Indices.
Binary Option Trading Example
A Binary Option reflects specific speculation in financial markets that may happen during a specific time period.
When the expiry level is equal to the strike price the contract will expire ‘at the money’. Normally, there will be a fixed cash settlement to be returned which is often the initial investment, however this depends on what was predetermined and agreed in the contract.
Crude Oil Trading example:
Crude Oil price is now 81.75$ and you want to speculate on the price movement of the share within a time frame of 1 hour.
If you think that Crude Oil will rise above this price level, than you should buy a binary call option – if the Crude Oil price closes above the current price level during expiry than the option will expire ‘in the money’, paying you the fixed odds return promised during the trade. If not, the option will expire ‘out of the money’.
If you think that Crude Oil will fall below this price level, than you should buy a binary put option – if Crude Oil price closes below the current price level during expiry than the option will expire ‘in the money’, paying you the fixed odds return promised during the trade. If not, the option will expire ‘out of the money’.
Differences between a Vanilla Options and a Binary Options
Binary options, also known as digital options, are similar to ordinary options in the sense that the payoff is based on the price of the underlying asset when the contract expires, however, with a binary option, the trader only needs to take a view on the anticipated direction of the underlying asset price and doesn’t need to take magnitude into consideration.
The main difference between a regular vanilla option and a digital option is the extent to how much a contract can potentially lose or gain. Binary options often referred to as FRO, fixed rate options, since the contract will have a predetermined percentage of fixed rate of return. Unlike traditional vanilla options which are much riskier, since the potential gains are infinite, of course risk can be managed by strategical stop loss orders.