Binary options may sound complicated, but they’re really not. In fact, they offer traders alternative ways to trade stock indices, commodities and currencies—even economic events.

Say you think the S&P 500 is going to rise, or the U.S. dollar will fall or the monthly unemployment report will be disappointing. Binary options allow you to trade these outcomes with a relatively small amount of money and limited risk.

As the term binary suggests, it’s an all-or-nothing trade. You either gain or lose if you decide to stay in your trade until expiration, although closing a position early, to lock in profit or limit loss, is also an option. Another benefit to trading binary options is at the time you place a trade, your maximum potential loss is known in advance. Additionally, the very nature of binary options is such that they provide trading opportunities in up or down trending, flat and even volatile market conditions.

Binary options give traders a very interesting way to capitalize on trading insights where the risks and payouts are fully known upfront.

How Binary Options Work

In every binary option, there’s a buyer and a seller—just like with any trade. The exchange is simply matching the buyers and sellers on every trade in a regulated environment.

Let’s say you think the price of gold will rise above $1250 by 1:30 pm the next day. You would buy a binary option that would pay off if gold was above $1250 at 1:30pm. Alternatively if you did not think the price of gold would be above $1250 by 1:30 the next day, you would sell that binary option.

When trading binary options, you’re not actually buying a gold futures contract, but simply making a prediction on the trading price level of gold futures at expiration. The initial cost of your binary trade depends on the gold futures price relative to the strike price and time to expiration.

The binary trading price range fluctuates between $0 and $100 and could be thought of as a probability. A binary price approaching 100 would be a high probability trade for the buyer and a very low probability for the seller.

Conversely, the binary price approaching 0 would be the opposite, high probability for the seller and low probability for the buyer. The binary trade price is equivalent to the trade probability for the buyer; the probability for the sell is $100 payout subtracted from the binary trade price.

So, if you think there’s a 40% chance gold will rise above $1250, you can buy a binary options contract for $40. The counter-party to that trade would pay $60 for the contract, predicting that there’s a 60% chance that gold will not rise above $1250.

So in your $40 trade, your maximum profit is $60 and your maximum loss is $40, not inclusive of exchange fees. The opposite is true for the person on the other side of the trade.

In considering the binary price as a probability, any trade price over 50, it could be said that the buyer has a statistical advantage over the seller that the contract will settle at 100. For this advantage, the buyer will be required to put up more collateral to place the trade than the seller. If the trade price is below 50, the seller could be said to have the statistical advantage. At a trade price of exactly 50, the probability as represented by price is exactly the same for both buyer and seller.

The risk/reward ratio of the binary trade is dependent on the amount of this advantage or disadvantage at the time the initial trade was executed.

The Bid/Offer Price

If you look at binary options on Nadex, you’ll see many different contracts with different bid and offer prices and numerous expirations. For example, here is a sample screen shot of Daily Binary Gold contracts. Let’s take a look at the Gold (Feb)> $1249.0 at 1:30 pm priced at 24.50/ 30.00.


The first price--24.50--is the best bid, which is the price that one is willing to buy the binary Gold > $1249.0 at 1:30pm. The buyer of the binary thinks gold (February) futures will finish above $1249.0 at 1:30pm EST expiration.

Binary Trade at 24.50:

Buyer cost: 24.50 (maximum loss)/ maximum potential gain of 75.50 at expiration…. 308% return

Seller cost: 75.50 (maximum loss)/ maximum potential gain of 24.50 at expiration…….32% return

The second price--$30.00--is the best offer, which is the price that one is willing to sell the binary Gold > $1249.0 at 1:30pm. The seller of the binary thinks gold (February) futures will finish at or below $1249.0 at 1:30pm EST expiration. If there is a binary trade at 30.00

Buyer cost: 30.00 (maximum loss)/ maximum potential gain of 70.00 at expiration…. 233% return

Seller cost: 70.00 (maximum loss)/ maximum potential gain of 30.00 at expiration……43% return

All examples above are not inclusive of exchange fees.

The bid/offer prices change throughout the day as the price of gold futures fluctuates above and below the relative strike price levels. The greater this price differential, the more predictable the binary becomes and is priced towards the extremes of either 0 or 100.

It is important to remember the movement in the price of a binary option and the ultimate settlement price, 0 or 100, are determined by the price of the underlying market (February Gold Futures in the example above). As such, when considering buying or selling a binary option, it is important to conduct your analysis based on the underlying market, rather than on the binary option price itself.

Futures, options and swaps trading involves risk and may not be suitable for all investors.

Related Articles
  1. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  2. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  3. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  4. Investing

    The Best Strategies to Manage Your Stock Options

    We look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.
  5. Investing Basics

    Retirement Planning Using Long-Dated Options

    Retirement planning using high-risk options? It is possible, and studies confirm better yields than conventional methods. Here’s how.
  6. Investing Basics

    Understanding Vega

    In options trading, vega represents the amount option prices are expected to change in response to a change in the underlying asset’s implied volatility.
  7. Options & Futures

    Introduction to Options Types

    Options are often the bread and butter of day traders. Here are some of the more common types of options.
  8. Options & Futures

    Use Options to Hedge Against Iron Ore Downslide

    Using iron ore options is a way to take advantage of a current downslide in iron ore prices, whether for producers or traders.
  9. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  10. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  1. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  2. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  3. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  4. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  5. What is the difference between derivatives and options?

    Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>
  6. How are rights distributed in a rights offering?

    In a rights offering, rights are distributed to shareholders based on the number of shares they already own. What Is a Rights ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  3. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  4. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  5. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  6. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!