What are binary options?
A binary option is a financial product in which parties involved in a transaction are assigned one of two outcomes depending on whether the option expires in the currency. Binary options depend on the outcome of a “yes or no” proposition, hence the name “binary”. If the binary option expires in the currency, the trader will receive a payout, and if it expires in the currency, the trader will suffer a loss.
- Binary options depend on the outcome of a “yes or no” proposition.
- If the binary option expires in the currency, the trader will receive a payout, and if it expires in the currency, the trader will suffer a loss.
- Binary options set a fixed payout and loss amount.
- Binary options do not allow traders to take a position in the underlying security.
- Most binary options trading takes place outside the United States.
Binary Options Outside the US
How Binary Options Work
Binary options have an expiration date and/or time. At expiration, the price of the underlying asset must be on the correct side of the strike price (based on the trade made) for the trader to make a profit.
Binary options are automatically exercised, which means that when the option expires, the gain or loss on the trade is automatically credited or credited to the trader’s account. This means that buyers of binary options will either receive payment or lose their entire investment in the trade – no relationship between the two. Instead, the seller of the option either retains the buyer’s premium or is required to pay in full.
Binary options can be as simple as whether ABC’s share price will rise above $25 on April 22, 2021 at 10:45 AM, a trader makes a decision, yes (will be higher) or no (will be lower).
Suppose the trader believes that the price will be above $25 at that date and time and is willing to put $100 into the trade. If ABC stock trades above $25 on that date and time, the trader will receive payment according to the agreed terms. For example, if the payout is 70%, the binary broker will credit the trader’s account with $70.
If the price trades below $25 on that date and time, the trader is wrong and loses $100 of his investment in the trade.
Binary Options vs Ordinary Options
Common American options give the holder the right to buy or sell the underlying asset at a specified price on or before the expiration date of the option. European-style options are the same, except that the trader can only exercise the right on the expiration date. Ordinary options, or simply options, provide the buyer with potential ownership of the underlying asset. When buying these options, the trader has a fixed risk, but the profit depends on how much the price of the underlying asset moves.
Binary options differ in that they do not offer the possibility of taking a position in the underlying asset. Binary options usually specify a fixed maximum payout, while the maximum risk is limited to the amount invested in the option. Changes in the underlying assets do not affect payments received or losses incurred.
Profit or loss depends 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 usually reduces the payout received (if the option is in the currency).
Binary options are occasionally traded on platforms regulated by the U.S. Securities and Exchange Commission (SEC) and other agencies, but most binary options trading occurs outside the United States and may not be regulated. Unregulated binary options brokers do not have to meet certain criteria. Therefore, investors should be wary of the possibility of fraud. Instead, common options are traded on regulated U.S. exchanges and are regulated by the U.S. options market.
Binary Options Example
Nadex is a US-regulated binary options exchange Nadex Binary Options is based on a “yes or no” proposition, allowing traders to exit before expiration. The entry price for binary options represents potential profit or loss, and all options expire worth $100 or $0.
Let’s assume stock Colgate-Palmolive is currently trading at $64.75. The binary option has a strike price of $65 and will expire tomorrow at 12 PM. Traders can buy the option at $40. If the stock price exceeds $65, the option expires and is worth $100. The trader makes $60 ($100 – $40).
If the option expires and Colgate’s price falls below $65 (out of the money), the trader will lose the $40 they put into the option. The potential profit and loss of Nadex binary options always add up to $100.
If traders want to make a more significant investment, they can change the number of options traded. For example, in this case, choosing three contracts would increase the risk to $120 and the potential profit to $180.
Non-Nadex binary options are similar, but they are generally unregulated in the US, generally cannot be exited before expiration, may not be traded in $100 increments, and usually have a fixed win percentage payout.