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.