“Binary options are types of financial options in which the payoff can take only two probable outcomes, either some fixed monetary amount of some asset or nothing at all.”
Two Main Types of Binary Options
- Cash-or-Nothing Binary Option
- Asset-or-Nothing Binary Option
The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security. On the American Stock Exchange, they are also called all-or-nothing options, digital options, and fixed return options (FROs).
When purchasing a binary option, the potential return it offers is certain and known before the purchase is made. Binary options can be bought on virtually any financial product and can be bought in both directions of trade either by buying a “Call”/“Up” option or a “Put”/“Down” option.
Binary options are offered against a fixed expiry time. The value of a digital option can be expressed in terms of the probability of exceeding a certain value, that is, the cumulative distribution function. Dealers often replicate them using vertical spreads, which provides a rough, inexact hedge.
Binary options contracts have long been available over-the-counter (OTC). This means that it is sold directly by the issuer to the buyer. They were often seen embedded in more complex option contracts. Since mid-2008, binary options websites called binary option trading platforms have been offering a simplified version of exchange-traded binary options. It is estimated that around 90 such platforms also including white-label product, have been in operation as of January 2012, offering options on some 200 underlying assets. The platforms offer consistent short-term binary options with a pre-determined profit/loss, that cannot be liquidated (buy or sell to close) before expiry, unless the platform or broker allow such liquidation. In a prediction market, binary options are used to find out a population’s best estimate of an event taking place. In financial markets, expected returns on a stock or other instrument are already priced into the stock. However, a binary options market provides other information. Just as the regular options market reveals the market’s estimate of volatility. In theory, a portfolio of binary options can also be used to synthetically recreate or valuate any other option.
Option strategies are the simultaneous buying or selling of one or more options that vary in one or more of the options’ variables. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straight forward strategy might simply be the buying or selling of a single option, however option strategies often refer to a combination of simultaneous buying and or selling of options.
The Trading System
Binary options are a simple way to deal price fluctuations in multiple global markets, but a trader needs to be aware of the risks and rewards of these often-misunderstood instruments. Binary options are different from traditional options. If traded, one will find these options have different payouts, fees and risks, not to mention an entirely different liquidity structure and investment process.
The most common binary option is a “high-low” option. Providing access to stocks, indices, commodities and foreign exchange, a high-low binary option is also called a fixed-return option. This is because the option has an expiry date/time and also what is called a strike price. If a trader wagers correctly on the market’s direction and the price at the time of expiry is on the correct side of the strike price, the trader is paid a fixed return regardless of how much the instrument moved.
A trader who wagers incorrectly on the market’s direction loses her/his investment. For most high-low binary options outside the U.S., the strike price is the current price or rate of the underlying financial product, such as the S&P 500 index, EUR/USD currency pair or a particular stock. Therefore, the trader is wagering whether the future price at expiry will be higher or lower than the current price.
A “range” binary option allows traders to select a price range the asset will trade within until expiry. If the price stays within the range selected, a payout is received. If the price moves out of the specified range, then the investment is lost. As competition in the binary options space ramps up, brokers are offering more and more binary option products. While the structure of the product may change, risk and reward is always known at the trade’s outset.
Binary Options – Win or Lose
There is an upside to these trading instruments, but it requires some viewpoint. A major benefit is that the risk and reward are known. It does not matter how much the market moves in favour or against the trader. There are only two outcomes. It is either winning a fixed amount or losing a fixed amount. Also, there are generally no fees, such as commissions, with these trading instruments.
The options are simple to use. There are also no liquidity concerns, because the trader never actually owns the underlying asset, and therefore brokers can offer innumerable strike prices and expiration times/dates, which is attractive to a trader.
A final benefit is that a trader can access multiple asset classes in global markets generally anytime a market is open somewhere in the world. The major disadvantage of high-low binary options is that the reward is always less than the risk. This means a trader must be right a high proportion of the time to cover losses. While payout and risk will come and go from broker to broker and instrument to instrument, losing trades will remain constant that will cost the trader more than he can make on winning trades. Other types of binary options may provide payouts where the reward is potentially greater than the risk.