[?] Subscribe To This Site

Binary Options

The Unique Properties of Binary Options

Binary options are not like regular options, even though they carry the same titles such as "calls" or "puts". On the upside, their pricing and profit components are far less complicated because time decay is not an issue. On the downside, they are normally very short term speculative trades based on where the underlying financial instrument will be in an intraday timeframe. If it's where you anticipated, you receive a fixed payout; if it's not, you lose most, but not all of, your investment.

The word "binary" means "two" so these types of options are well named. There are only two outcomes - you get paid or you don't. Sometimes they are called all-or-nothing options, digital options or fixed-return-options (in the USA).

In some ways you could think of it like betting on a horse race. The thing is, there are only two horses in this race - one is called "up" the other "down". If you pick the right one, you win; if not, you lose about 90 percent of your investment. Binary options usually have a good return on risk percentage - often way above 50 percent and that ultimately means that providing you get more trades right than wrong, you make an overall profit.

Binary options can also be used for short term range trading. Instead of your objective being that the price will be above or below a certain price level, you're now speculating that the price of the underlying will trade within a specified range during an agreed period of time. These are called "hit or miss options". The trader chooses the price range and the timeframe and the broker then creates a price. If the underlying trades within the price range during the short timeframe specified, you have a "hit" and get paid.

Binary Options Pricing

Like regular options, the pricing of binary options includes the component of implied volatility and this means you will need to analyze the price given to ensure there is value in the binary call or put options you intend to purchase. The important thing is to have a plan which includes an appropriate return on investment for winning trades that is sufficient to cover the anticipated number of losses. For example, a minimum 70 percent profit on each winning trade and 10 percent loss on losing trades means that you need to get 6 trades out of 10 right in order to make an overall profit. If you accept less than 70 percent ROI then the required number of profitable trades will increase.

Binary options are never exercised so you will never be landed with the underlying financial instruments at expiration date. The result is really simple - you either get paid or you don't. They are usually European-style options because they are only settled in cash at expiration. The payout is either cash-or-nothing or asset-or-nothing. In both cases, you are paid in cash, which is the value of the asset. Binary options can be traded on stock indexes, currency pairs or individual stocks.

Let's take a look at an example:

Suppose it's 11am and the EUR/USD currency pair is trading at 1.3480. You believe that it will close at or above 1.3500 by 2pm today. So you buy 10 binary call option contracts with that strike price, at a cost of $40 per contract = $400 cost. If the EUR/USD is at or above 1.3500 come 2pm, you get paid $100 for each contract. Below that you get nothing.

The expiration time comes and you're in luck. Your profit is $1,000 less the $400 cost of the options, ie. $600. You risked $400 and made $600 which is 150 percent return on investment. Well done!

The simplicity of binary options has made them attractive to speculative traders and their introduction in July 2008 has opened up yet another way to trade options.

**************** ****************

Return to Explain Option Trading Contents Page

Go to Option Trading Homepage