A binary option is an option where you are either payed in full at the day of maturity or is paid absolutely nothing (and lose the money you paid for the binary option). This is what makes it binary. With a standard (i.e. non-binary) option, there is a sliding scale and you may lose everything, make some money, make quite a lot of money, etc. With a binary option, you either win or lose, and how much you get if you win is typically determined in advance.
Your task when purchasing a binary option is to correctly predict the movement of the underlying. The underlying can for instance be a share, a currency pair, a commodity or an index.
For the classical type of binary option, you must predict if the underlying will be above certain prize level when the binary option matures (the expiration time). For non-classical binary options, your task can be quite different. There are for instance binary options where you must predict if the underlying will reach a certain prize point at any time during the lifetime of the binary option. With such a binary option, the entire lifetime of the option is important, not just the prize of the underlying when the binary option matures.
Binary options are marketed under several different names, including All or Nothing Options, Fixed Return Options (FRO) and Digital Options. The classical type of binary option is also known as the Over/Under Option.
Binary options contract
The binary options contract is important because this is where you will find important information about the option. The contract should outline what type of binary option it is, when it matures, the underlying, etc. For most binary options, the contract will also stipulate exactly how much you will get paid if you get paid.
For some options, you don’t get paid in money – your reward is instead something else, e.g. becoming the owner of a pre-specified asset. Such binary options can be used as stepping stones to building up an investment portfolio consisting of financial instruments or other assets. Instead of purchasing the assets outright and pay the market price for them, you “win” them by successfully trading in binary options.
Cash or nothing binary option = a binary option where your reward for being right is cash
Asset or nothing binary option = a binary option where your reward for being right is an asset (not cash)
Examples
So, what can binary option trading look like? Below you will find a few examples.
Example #1
You purchase a €10 cash or nothing binary option stating that the share price for an A-share in Company QQQ will be over $100 on NYSE closing exactly four days from now (this is the expiration date for the binary option, also known as maturity date). According to the binary option contract, you will be rewarded with €1,500 if your right.
On the expiration date, the price for an A-share in Company QQQ is $101 at NYSE close. Your prediction has come true and you receive €1,500.
If, for instance the, the price for an A-share in Company QQQ had been $95 at NYSE close, you would have been paid nothing at all. With a classic binary cash-or-nothing option, there is no reward for being almost right. Since an option always becomes worthless once it has expired, this trade would have ended with a €10 loss for you.
If the price of an A-share in Company QQQ had been $500 at NYSE close, you would still only have been rewarded with €1,500. You don’t get a bigger reward just because the share price exceeds your prediction with a very wide margin.
Example #2
You purchase a €10 asset-or-nothing binary option stating that the share price for an A-share in Company QQQ will be over $50 on NYSE closing exactly four days from now (this is the expiration date for the binary option, also known as maturity date). According to the binary option contract, you will be rewarded with one (1) A-share in Company QQQ if your right.
On the expiration date, the price for an A-share in Company QQQ is $55 at NYSE close. Your prediction has come true and you are now the owner of an A-share in Company QQQ.
The underlying asset and the asset your get for being right doesn’t have to be the same. The binary option contract can specify that you get a completely different asset if your right, e.g. a B-share in Company QQQ or an A-share in Company TTTTT or five A-shares in Company ABCDE. It doesn’t even have to be a share; it can be any type of asset. It’s always important to check the binary option contract before purchasing a binary option.
The popularity of the binary option
The popularity of the binary option has many reasons, and each trader has their own set of reasons for trading in binary options. Here are a few common reason reason.
Low purchase price
Some (but definitely not all) binary options have a very low purchase price. Do you have good reasons to believe that the share price of Company QQQ will rise this week, but can’t afford to buy even a single share in the company? Purchase a low-price binary option instead, and profit from the increased share price without actually owning any shares in the company.
Less risky than selling short
Do you have good reasons to believe that the share price of Company QQQ will go down this week? The traditional way of profiting from this has been the short-sell. To put it simply, this is how you would do a short-sell: You borrow shares in Company QQQ from someone, e.g. your stock broker. You sell them to a third party for the current market price. You wait until the market price of the share goes down, then you buy enough shares in Company QQQ to give back to the entity that lent you the shares.
Of course, short-selling can be very risky because your can lose an indefinite amount of money.
Example: You borrow 100 shares in Company QQQ from your stock broker and promise to return them on May 31 this year. You immediately sell the shares for $200 each, and thus get $20,000. You believe that the share price will drop down to $175 so that you can buy 100 shares in Company QQQ for $17,500 and make a $2,500 profit, but this doesn’t happen. You wait and wait, and on May 31 you are obliged to purchase 100 shares in Company QQQ to give back to your broker. Company QQQ has been doing great and the share price is now $300. You have to pay $300 x 100 shares = $30,000. Short-selling Company QQQ resulted in a $10,000 loss for you.
Since there is no ceiling for how high the price of a share can soar, there is no limit for how much you can lose with a short-sell. This is why many cautious traders prefer to go with a binary option instead, if they think that the share price of a company will drop.
Example: The share price for Company QQQ is currently $200 but you think it will be down to under $176 on May 31 this year. You purchase a €100 binary option that says that you will receive a payment of $2,500 if your prediction comes true.
On May 31, the share price for Company QQQ is $300, just as in the example above. But you only lose the €100 you paid for the binary option. In addition to losing less, you also knew beforehand exactly how much you would lose if your prediction would not come true. There was never any risk of you ending up losing more than €100.
Low investment – high yield
It is possible to find binary options where the payment if you are right is very big compared to the purchase price. Some novelty binary options will pay you over 500%! A profit of 90% or somewhere in that area is the rule of thumb for classical binary options, but always check the options contract before you make a purchase. Still, a quick 90% profit is a very large profit compared to what we can expect to make if we invest directly in company shares, a currency, or similar. Even if the share price, currency value, etc goes up, a quick 90% increase in value is exceedingly rare. There are exceptions though, so called penny stocks are known to be low in purchase price and sometimes rapidly go through a major increase (or decrease) in price. If you are okay with high risk, something which is true for most binary option traders, penny stocks might be an interesting compliment to your binary option trading.