Binary Options

Binary options trading , once limited to the over-the-counter (OTC) market, has been gaining in popularity since its acceptance by the SEC in 2007. While similar to trading traditional options, there are some special features that make trading binary options different. Before one commits any personal capital to this pursuit, it is important to understand these subtleties.

The Binary Difference

Unlike tradition options, binary options are classified as being all-or-nothing in their payout structure. This means if the condition of the option is met, the contract pays out a fixed amount of either cash of some predetermined asset. If the condition of the option is not met, the option expires worthless. This differs from traditional options, whose value at the time of expiration is directly related to the price of the underlying. For example, with a traditional call option at expiration, the higher the price of the underlying, the more the option will be worth.
Given this set amount of payoff, and the chance that the option may expire with no value at all, binary options tend to have relatively high payout amounts relative to their price. While there is no set rule, it is not uncommon to expect a return of roughly 75% for this type of contract. If these options are carefully understood, they have the potential to net significant gains for the successful investor.

The Components

A binary option has three basic components which must be understood before one begins to trade binary options : the underlying asset, the expiration structure, and the trend of the underlying.

The Underlying Asset – As with any options contract, a binary option is based on the price of some underlying asset whose movement is the subject of the contract. This asset may be a stock, an ETF, or a currency pair, but in all cases, its movement is independent of the option. More specifically, the underlying asset will continue to trade regardless of the existence of any options contracts.

The Expiration Structure – This structure involves the inclusion of an expiration date and a strike price. The strike price is the target price of the underlying asset on which the option is based. For example, if a binary call option has a strike price of $100, this means that if the underlying asset is trading at or above $100 at the time of expiration, the options pays off. Because we are dealing with binary options, if the price is below the strike price at the time of expiration, the option expires worthless.

The Trend of the Underlying – This is the critical piece of information for a potential investor to understand and analyze before investing in a binary option. If the trend is upwards, and appears likely to carry above the strike price by the time the binary option expires, the investor should invest in a call option to realize a profit. Conversely, if the price trend of the underlying asset is downward, and appears likely to carry below the strike price by the time the binary option expires, the investor should invest in a put option to realize a profit. This analysis is the key to making successful investments in binary options.

A Word on Advanced Trading Techniques

As a result of the all-or-nothing nature of binary options, they have certain features that distinguish them from traditional American style options. The Black-Scholes option pricing model actually builds in the all-or-nothing type assumption into its calculation. This means that this model, and many of its outputs, called Greeks, will be more accurate for binary options than for traditional options. This can give potential investors a way to make even more informed decisions before placing trades.