Derivative contracts were born because of people’s innate desire to circumvent uncertainty. A derivative contract is a contract drawn up between two parties, the price of which is derived based on an underlying asset.
- What are binary options?
- Evolution of binary trading options
- Types of binary options
- Cash-or-nothing vs. asset-or-nothing
- Other terms
- Breadth of underlying assets
- Binary options example
- Advantages to binary options trading
- Disadvantages of binary options trading
- Brokers that allow binary options
- Final thoughts
The widely-used derivatives include futures, options, swaps, and warrants. A futures contract provides for buying or selling an asset at a predetermined price at a future date, while an option contract allows the purchaser of the option the right to sell or buy a specific asset at a later date at an agreed-upon price.
Apart from the basic, plain vanilla put and call options, variants called exotic options are also available. An exotic option is a little more complex, with special features or pay-off structures intended to meet specific needs of investors.
One example of an exotic option is the binary option.
What are binary options?
Binary options, as the name implies, has two possible outcomes:
- The price of the underlying asset finishes either above or below the specified price at the specified time. It can be categorized as one of the simplest financial assets.
- Based on a “yes” or “no” proposition, it allows an individual to trade, although the risk, as well as profit potential, are capped.
Binary options basics
Evolution of binary trading options
Binary options became available for retail traders following SEC approval in 2008.
Previously, binary options trading existed but was available only to banks, institutional investors or high net-worth individuals through the over-the-counter market.
In 2007, when the subprime mortgage crisis began to rear its ugly head, the Options Clearing Corporation, or OCC, embarked upon the job of developing regulatory framework for the options market, while also proposing changes to upgrade binary options to the status of a financial asset that could trade as a standalone instrument in major exchanges.
Following SEC approval, the Chicago Board Options Exchange (CBOE) and the American Stock Exchange offered binary options to retail traders. In its early days, binary options came with a lot of restrictions such as the availability of merely call options and options on the S&P 500 Index.
Slowly and steadily, the popularity of binary options increased amid the broadening of the variety of binary options available for trading and the improvement in the trading software that now allows online and mobile app trading.
Types of binary options
- High/low option (above/below option): This is the most popular type of binary option. An investor bets on the underlying asset going above or below the predetermined price at the time of expiration.
- Touch option: An asset will touch the strike price at the time of expiration.
- Range option: The asset is in a predetermined range by the time of expiration.
- 60 seconds option: As the name suggests, the 60 seconds option expires in 60 seconds from the time of purchase. A trader in the 60 seconds option should be quick and adequately backed up by a trading software with a best-in-class charting program.
Cash-or-nothing vs. asset-or-nothing
There are two forms of options: cash-or-nothing and asset-or-nothing.
A cash-or-nothing option pays a trader a fixed amount of money or nothing at all, while an asset-or-nothing options also has a fixed payoff but the payoff is equal to the price of the asset.
- Underlying asset: The asset on which the binary option is based upon, or a security used in the binary options contract.
- Call: An option contract drawn up by a trader who believes the price of the underlying asset will increase by the time the option expires.
- Put: An option purchased by a trader who believes the price of the underlying security will drop by the time the option expires.
- Strike price: The price of an underlying asset at the time of the purchase of the binary option, compared against the price of the asset at the time of the expiry of the option.
- In-the-money, or ITM: An option is in-the-money if a call option’s strike price is below the market price of the underlying asset, or if the strike price of a put option is above the market price of the underlying asset.
- Out-of-the-money, or OTM: When the strike price of a call option is above the market price of the underlying asset or when the strike price of a put option below the market price of the underlying asset, then the option is out-of-the-money.
Breadth of underlying assets
Binary options provide for trading a host of underlying assets, some of which are:
- Currency pairs
Binary options example
Assume the bid and ask price of a binary options contract for the EUR-USD currency pair at greater than $1.415 are $30 and $34, respectively. A trader who believes the pair will close above the $1.415 level at 4 p.m. ET, will buy the call option at $34.
Since the option can increase in value to $100 or drop to $0 depending on how the EUR-USD pair moves, a traders makes a profit of $66 (if the pair trades above $1.415 at the specified time) or incurs a loss of $30 (if the pair trades below) $1.415 at the specified time.
Sample binary options trade
The price of the binary option is determined by the market, based on the likelihood of the proposition implied by the contract coming true. If the odds are less, the option price will be low (say $10 or $15).
If you invest $100 in a call option in the S&P 500 Index, which is currently trading at 2,875 (strike price), with an expiration time of 30 minutes, you stand to gain $100, plus a payout (if specified in the contract) if the index is above 2,875 at the expiration time.
The expiration time can be the last traded price or the average of the bid and ask price, depending on the terms set by the broker.
However, if your binary option expires out of the money, or the index is trading below the strike price, you stand to lose your $100.
If the market price is exactly at the strike price at the time of expiration, then you preserve your investment, without any profit.
Advantages to binary options trading
- You’ll know both the risk and reward in advance, or at the time a contract is struck
- Binary options expire quickly and can generate substantial returns with a few quick, successful trades. Expiry period could range from 15 minutes to up to a week or two.
- Investments could be as little as $10.
- Binary options provide an opportunity to trade with a wide range of assets available all over the world.
Disadvantages of binary options trading
- Since some of the binary options brokers are loosely regulated, you might face the risk of losing your money if your broker opts to hoodwink you.
- Since binary options trading is more of a speculative activity, despite the research and analysis going into it, the outcome of the investment is not always a certainty.
- Earnings potential is limited relative to the movement in the underlying asset. Despite whether an underlying instrument moves $1 or $100 in the desired direction, your return is limited to the price of the binary option.
Brokers that allow binary options
You’ll find that a lot of brokers allow for binary options trading. However, some of them aren’t trustworthy or fall far below the threshold for acceptable brokerages. You can read more about this in our Best Binary Options Brokers guide.
Since binary options trading comes with its own set of pros and cons, you’ll have to determine if it’s the right way to go for you. After all, limited regulations and limited profit potential can render it an unattractive option. However, there’s no denying of the fact that binary options are an excellent practice ground for a beginner who wants to take the plunge.