What is a Binary Option
A binary option is a derivative financial product with a fixed (or maximum) payout if the option expires in the money, or the trader losses the amount they invested in the option if the option expires out of the money. The success of a binary option is thus based on a yes or no proposition, hence “binary”. Binary options have an expiry date and/or time. At the time of expiry, the price of the underlying asset must be on the correct side of the strike price (based on the trade taken) in order for the trader to make a profit.
A binary option automatically exercises, meaning the gain or loss on the trade is automatically credited or debited to the trader's account when the option expires.
Breaking Down the Binary Option
Binary options are based on a yes or no question. For example, a binary option may be as simple as whether the share price of ABC Company will be above $25 on November 22nd at 10:45 am? The trader can choose either Yes (it will be higher) or No (it will be lower). Say the trader thinks the price will be above $25, on that date and time, and is willing to bet $100 on it.
If the price of ABC shares are above $25 on that date and time, the trader receives a payout which was established at the time the trade was taken. This may be a 70% payout for example, so $70 is credited to the trader's account. If the price is below $25 at that date and time, the trader was wrong, and thus loses their $100 investment in the trade.
Difference Between Binary and Vanilla Options
A vanilla American option gives the holder the right to buy or sell an underlying asset at a specified price before the expiration date of the option. A European option is the same, except that the right can only be exercised on the expiration date. Vanilla options, or just "options," provide the buyer with potential ownership of the underlying asset. When buying these options the risk is capped, but profits will vary depending on how far the price of the underlying asset moves.
Binary Options Outside the US
Binary options differ in that they don't provide the possibility of taking a position in the underlying asset. The binary option typically provides a fixed maximin payout and fixed maximum risk which is limited to the amount invested in the binary option. These payouts or losses are not affected by how far the underlying asset moves. The profit or loss is only dependant on whether the price of the underlying is on the correct side of the strike price. Some binary options can be closed before expiration, although this typically reduces the payout received (if the option is in the money).
Binary options are occasionally traded on platforms regulated by the Securities and Exchange Commission (SEC) and other regulatory agencies, but most binary options trading occurs outside the U.S. and may not be regulated. Binary options brokers that operate unregulated are not held to a particular standard, and thus investors should be wary of the potential for fraud. Conversely, vanilla options trade on regulated exchanges in the U.S. and are thus subject to greater oversight.
Binary Options Example
Nadex is a regulated binary options exchange in the U.S.. Nadex binary options are based on the yes/proposition, and allow traders to exit before expiry. The price the binary option is entered at indicates the potential profit or loss, with all options expiring worth $100 or $0.
Assume stock XYZ is currently trading at $64.75. A binary option has a strike price of $65 and expires tomorrow at noon. The trader can buy the option for $40. If the price of XYZ finishes above $65, the option expires in the money and is worth $100. The trader makes $60 ($100 - $40).
If the option expires and the price of the stock is below $65, the trader loses the $40 they put into the option. The potential profit and loss, combined, always equals $100 with a Nadex binary option.
If the trader wanted to make a larger investment, they could change the number of options being traded. For example, selecting three contracts, in this case, would up the risk to $120, and increase the profit potential to $180.
Non-Nadex binary options are similar, except they typically aren't regulated in the U.S., often can't be exited before expiry, usually have fixed percentage payout for wins (whereas Nadex payouts fluctuate based on the price paid for the option), and may not trade in $100 increments.