Binary options are contracts where an investor is speculating on one of two outcomes: a payoff or nothing at all. The deciding factor is whether or not the option is in the money at the expiration date.

You can trade binaries on events or on investments—such as stocks, futures, foreign currency, and exchange-traded funds (ETFs). While the concept is relatively straightforward, there are many misconceptions about binary options, so it is important that traders understand exactly what they are—and are not—in order to use them effectively.

Understanding Binary Options

At least on the surface, binary options are structured just like a $100 bet on a football game: You buy the team you like, or you sell the team you don’t like. A binary is just a simple "yes or no" trade. The "yes" trade means you agree with the binary statement—for example, that the market will reach a certain level before expiration. The "no" trade means you disagree. The pricing of the binary is between zero and $100.

Key Takeaways

  • Binary options are a type of contract that allow investors to speculate on an outcome.
  • If correct, the option holder receives a payout; if not, they receive nothing at all.
  • People trade binaries on stocks, futures, foreign currency, and exchange-traded funds (ETFs).
  • The big difference between binaries and standard put and call contracts is that the payout is either $100 or nothing at all.
  • Time frames for binary trades can be days, hours, minutes, and even seconds.

Unlike football, where the underdog receives the better odds, the binary has a multitude of strike prices—that have a variety of fixed odds—based on the current price of the underlying. Like any investment, there is always a tradeoff between risk and reward.

For example, if you buy a binary priced at $20, there is a low probability of it paying off: Your cost is only $20, while your potential profit is $80. In other words, it's a long shot. On the other hand, if you sell a binary priced at $20, then there’s a high probability of it paying off. But your cost is $80, while your potential profit is $20.

Buying and Selling Binary Options

As you look at the various strike levels of a particular binary option, you might notice some similarities to call options. As a binary buyer, you’re bullish about the underlying market. The at-the-money binary (where the market price is near the strike price) will be priced around $50.

The binary at expiration is valued at $100 if the underlying market finishes above the strike price—so the various strike levels will draw a similarity to in the money, at the money, and out of the money call options. The higher the strike price, the greater the chances that the contract will be in the money at expiration and, therefore, the higher the cost of the contract.

Binaries can also be used as a hedge, just like standard put options. To sell a binary, you are taking the opposite view; you’re bearish on the underlying market and think it will finish at or below the strike at expiration. You go short the binary at the trade price. The big difference between binaries and standard put and call contracts is that the payout is either all or nothing.

Exiting Before Expiration

Binary options are not buy and hold contracts for long-term investors. The expiration date is the moment of truth; that is when the final value of the binary is calculated. After that, the option ceases to exist and the trade is over.

When you initiate the binary position, your initial trade cost is your maximum exposure, so you’re either long or short the binary at the binary trade price. In a long binary position, you want the price to increase to $100, while in a short binary position you want the binary pricing to fall to zero. However, at any point prior to the expiration, the binary position can be offset to cut trading losses or lock in a trading profit.

Binary Options Are Regulated

Many binary options that are traded outside of the United States are not regulated. However, in the U.S., there are three exchanges, regulated by the Commodity Futures Trading Commission CFTC, offering binary options trading. Nadex is the first and largest for individual traders.

If you are trading binary options on a regulated exchange, you will be provided accurate and up--to-date time and sales data on all bids, offers, and trades throughout the trading session. That's because the exchange, which is simply matching buyers and sellers on every trade, provides this information in real-time.

Binary trades can last days, hours, minutes, or even seconds, which ups the odds for short-term profits or losses.

Capital Requirements

All binary options are priced between $0 and $100; the minimum amount to open an account with Nadex is $250. Since you are never trading on margin, your account always needs to have sufficient funds to cover the initial cost of the trade (plus trading fees). With binary options, the maximum risk and the potential profit are clearly defined by the terms of the trade.

The Bottom Line

There are many misconceptions about binary options. While some people use them as a form of gambling, these contracts can be used in other ways as well, such as hedging. The costs of a contract will vary depending on where the market price is relative to the strike price. When buying a binary, the goal is for the asset to close above the strike price. If so, the investor gets the payout. If not, they get nothing and lose their initial investment.