Introduction to Binary Options
A binary option is an option that pays either a fixed amount or nothing, depending on whether a certain condition is fulfilled when the option expires.
Binary options are also referred to as all-or-nothing options, since it is a type of option where the payoff is all or nothing. The return is therefore fixed and it comes to no surprise that such options are also known as: FRO's-Fixed Return Options. Digital options is also another commonly used term. More simply a trader just needs to make a decision about the direction of a rate change: whether the underlying asset's price is going up or going down without taking other factors into consideration.
Binaries are considered to be one of the simplest trading products out there, The trader knows at the time of the trade what is the maximum profit and loss.
Binary Options trading is considered as one of the fastest growing segments of the simplified trading products.
Binary options are fixed-odds-return investment products that have two possible absolute outcomes with structured reward and risk, hence the word 'binary'.
Binaries are considered as a mass market financial instrument as it empowers traders with a very flexible trading approach without the complexities involved in trading traditional vanilla options.
Whether you are looking for a short term speculation or hedging your portfolio, binaries can help you get a high payout within short trading durations as so, binaries are gaining popularity among traders globally.
Binary contracts are available on a variety of underlying assets:
Stocks, Commodities, Currencies and Indices.
Whether the trader has made a call or put, if at contract expiration the trader has been successful with regards to the anticipated direction of the underling asset price then the contract will expire in the money. On the other hand, if the trader has been unsuccessful in anticipating the direction of the asset, the contract will expire out of the money.
When the expiry level is equal to the strike price the contract will expire at the money. Normally, there will be a fixed cash settlement to be returned which is often the initial investment, however this depends on what was predetermined and agreed in the contract
A Binary Option reflects specific speculation in financial markets that may happen during a specific time period.
For example: Google price is now 430.25$ and you want to speculate on the price movement of the share within a time frame of 1 hour.
If you think that Google will rise above this price level, than you should buy a binary call option- if the Google price will be above the current price level during expiry than the option will expire in the money, paying you the fixed odds return promised during the trade. If not, the option will expire out of the money.
If you think that Google will fall below this price level, than you should buy a binary put option- if Google price will be below the current price level during expiry than the option will expire in the money, paying you the fixed odds return promised during the trade. If not, the option will expire out of the money.
Difference between vanilla options and binary options trading
Binary options also known as digital options are similar to ordinary options in the sense that the payoff is based on the price of the underlying asset when the contract expires, however with a binary option only need to take a view on the anticipated direction of the underlying asset price and don't have to take magnitude into consideration. The main difference between a regular vanilla option and a digital option is the extent to how much a contract can potentially lose or gain. Binary options often referred to as FRO fixed rate options since the contract will have predetermined percentage of fixed rate of return, unlike traditional vanilla options which are much riskier since the potential gains are infinite of course risk can be managed by strategical stop loss orders.
Vanilla Options Vs. Binary Options
|Binary Options||Vanila Options|
|Expiration||Variety of expiration terms: end of day, hourly and Even shorter expiration like 15 min binaries.||Once a month.|
Dynamic, based of the
underlying asset price.
|In-The-Money||Price movement isn't relevant, just the direction (above or below).||Requires a relation of the strike price of an option and the underlying price in order to execute the option.|
|Execution||Can't be exercised before expiry.||
Options usually can be exercised any
time prior to expiry.
|Right to buy||Don't have the right to exercise to stocks.||The option owner has the right to exercise his options and turn them into stocks in case option expires 'In-the-money'.|
Advantages of Binary Options
Simplicity-Whether the instrument will close above or below?
- Binary options are simple to understand and straight forward to trade.
The trader only needs to consider the direction of the asset price.
Limited risk and predetermined payout
- The payoff of a binary option contract is fixed and pre-determined so therefore the potential risk and reward is known from the outset. Whereas with traditional options there are no outlined parameters so the possible loss or gain is not known.
- The binary option will settle the contract irrespective of how much the asset price is 'In the money' at expiration. Therefore even if the contract is only successful by one tick the contract still pays out at the fixed level.
- Simplified hedging your portfolio
- Binary options are often used as an effective tool to hedge existing positions. As a product Binary options are compatible to most commonly used trading methods and strategies. Also with binary options its possible to offer a a greater selection of short-term contracts across all markets, which enables the intra-day trader to trade more frequently.
- As opposed to vanilla options, While trading binary options the options can close 'in the money 'collecting the full payoff even with a minimal price change of a single tick.
- Binary options are issued 24/7, allowing traders to trade on multiple time frames. As binaries are on a variety of global underlying assets from different exchanges traders are now able to trade binary options 24/7 under the same binary options platform.
Binary Options Strategy
A very common strategy is to make a pull or call option once there has been a big move in the market especially if it is an unexpected move.
Often binary options' traders will open positions related to events that historically have a big influence on market prices. Fox example quarterly profit or loss announcements from firms are eagerly watched by potential traders and betters, since positive or negative results often reflect the movement of the share prices. As well as formal preplanned announcements traders will always be watching the news, as many different events can influence the markets i.e. Natural disasters to political changes. Eventually the best strategies come with experience which cant be taught.
Binary Options in Global Financial Markets
Binary options falls under the umbrella of exotic options but within financial market they are often referred to as digital options.
Whilst digital options are very simple to understand and easily traded the calculations behind the pricing is sophisticated, its for this reason digital options are known as an exotic option.
Digital options are usually traded OTC (over the counter) across all assets in financial markets but more commonly used within the Forex and Interest markets. More recently numerous stock exchanges have produced listed digital options on selected stocks, commonly known as FRO fixed return options. Today the CBOE offers fixed return options on S&P500 and VIX, also 20 stocks were listed on the AMEX in 2008.