Next video:

A binary option is a type of option where the payoff depends on both the price levels of the strike and the underlying asset, like standard options.

If the underlying market is higher than the strike price of the binary option at expiration, it is considered to be “in the money” or true, and the buyer of the binary option would receive a fixed payout of \$100 per contract. If at expiration the underlying market is at or below the strike price of the binary, it is considered “out of the money” or false and the seller of the binary option would receive the \$100.00

The binary statement is a simple "yes" or "no" proposition to which you either agree or disagree. If you think "yes, it will happen," you buy the binary. If you disagree and think "no, it won’t happen," you sell the binary.

Unlike standard option contracts, the binary option does not give Mike and Jason the right to buy or sell the underlying asset. At expiration, it’s over! The binary is worth \$100 per contract - Who’s right? Mike or Jason?

The binary traded price for Mike and Jason is not the actual price of silver, but rather a weighted dollar value of the fixed \$100 payout. The binary pricing will range between 0 and 100 and can be described as being the probability and market perception of whether the binary proposition will be true or false at expiration. Even though the underlying silver futures market is trading for \$20.18, the March binary silver option contract to be above \$20.40 at 1.30pm tomorrow, is priced at \$14/\$15. Let’s assume Mike and Jason traded this binary at \$14.

The binary pricing constantly changes throughout the duration of the option, which depends on the underlying silver price compared to the strike. Mike is long two contracts at \$14; his cost is \$28. Jason is short two contracts at \$14; his cost is \$172, calculated as (100 - 14) x 2. Mike wants the binary price to rally and settle at 100. Jason wants the binary price to sell off and settle at 0.

At 1:30 p.m. tomorrow, the binary expires. If silver remains below \$20.40, the settlement price will be 0 and Jason receives \$100 for each contract or \$200 total. His net profit is \$28 (or \$200 gross profit – \$172 cost of shorting the option), and Mike gets nothing.

On the other hand, if silver rallies and finishes above \$20.40 at expiration, the settlement price will be 100 and Mike receives \$100 for each contract or \$200 total. His net profit is \$172 (or \$200 gross profit - \$28 cost of buying the option), and Jason gets nothing.

Both Jason and Mike have clearly defined risk and payout terms given their market view for silver futures using binary options. The contracts are fully collateralized so each party’s initial cost will be the other party’s net profit at expiration if they are correct.

Binary options offer a multitude of trading opportunity choices ranging from the underlying markets of spot FX, commodity and stock index futures, duration choices of two-hour, one-day and weekly options, as well as a vast array of strike price levels - all with limited risk tailored to your liking.

Futures, options and swaps trading involves risk and is not appropriate for all investors.

In This Series

6. What Is Inflation?

Related Articles

There are many misconceptions about binary options, so it is really important that traders understand exactly what they are--and what they are not--in order to use them effectively.

A Guide to Trading Binary Options in the U.S.

What binary options are, how they work and where you can legally trade them in the United States.

Binary Options FAQs - Sponsored by Nadex

Many investors may not be familiar with binary options, but they’re actually quite easy to use. And they can play an important role in your investing strategy. Here are some of the more common ...

Introduction To Binary Options - Sponsored by Nadex

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 ...

Trading Forex With Binary Options

Binary options are an alternative way, with a major advantage, for traders to play the forex market.

Binary Options Strategies - Sponsored by Nadex

Because of their all-or-nothing character, binary options offer traders a great way to trade on the direction of an asset or the overall market. And what makes binary options intriguing, besides ...

How To Hedge Call Options Using Binary Options

Here is a step-by-step walk through how to hedge a long call position with binary options.

How to Trade Volatility Using Binary Options - Sponsored by Nadex

Binary options are similar to classic options with some slight nuances but the components used for the option’s pricing are the same; underlying market, strike (K), volatility and time.

Risk and Reward of Binary Options Outside the US

Binary options offer a simple way to trade price fluctuations in global markets, but they’re not the same as traditional options.
Hot Definitions
1. Payback Period

The length of time required to recover the cost of an investment. The payback period of a given investment or project is ...
2. Collateral Value

The estimated fair market value of an asset that is being used as loan collateral. Collateral value is determined by appraisal ...
3. Fiduciary

A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
4. Current Account

The difference between a nation’s savings and its investment. The current account is defined as the sum of goods and services ...
5. Liability

Liabilities are defined as a company's legal debts or obligations that arise during the course of business operations.
6. Quick Ratio

The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...