Just like our regular options, binary options also allow us to bet on the future price of a stock. Binary options are different in a way that if the “strike price” is reached by the expiration date, the binary option has a pre-determined pay off of $100 per contract. It does not matter if the stock price is just a little above the Strike price.
Binary means ‘2’, which means they have only two payoffs, everything or nothing ($100 or $0). In 2008 the American Stock Exchange (AMEX) and CBOE started binary options on few stocks and few indices. A Binary option is not available for trading in many stocks even today. Stock exchanges all over the world are slowly accepting binary options trading. Now they are strongly related to forex. Let us take an example to understand binary options.
Example of Binary option
Suppose Facebook is trading at $600 a share. And you think it will close at or above $610 by this week. You then go for buying a binary option for a price of $0.5. The multiplier of binary option is 100. So buying 5 of these contracts will cost you 100*0.5*5, which is equal to $150.
If Facebook closes at $610 or higher by the expiration date, then you will be in the money. That means your option contract is worth $500, which is obtained by multiplying $100 to 5 call options. But your net profit would be, $500-$150, which is $350. It does not matter if Facebook closed at $610 or $700. Your contract is still worth only $100. On the other hand, if Facebook closes at $609 or any price lower than that, the option will expire worthlessly.
Today, all binary options are traded in the European style. This means they can only be exercised at expiry. U.S. offers binary options in two instruments, namely the S&P 500 Index and Volatility Index. But the problem is that only a few brokers offer binary options. So there is also a lot of risks associated with it.
Types of Binary options
The most commonly used binary option is the simple “Up/Down” trade. However, we can look at some other types of binary options also. One thing that is common in all types is a binary result “Yes/No”.
- Up/Down – This determines whether the price will be higher or lower than the current price at the time of expiry.
- In/Out – This type of option sets a “high” value and a “low” value. Traders try to predict whether the price will expire within these boundaries or outside it.
- Touch/No touch – Levels are set by default in this type of option. The trader’s job is only to predict whether the price will “touch” those levels. This should happen before expiration. In a touch option, it is only sufficient for the price just to touch those levels regardless of what happens next. It gives immediate payoff without having to wait till expiry.
- Ladder – Their working is similar to Up/Down option. But here the difference is in current strike price. The Ladder does not use the current strike price; rather, they have preset price levels. These levels are progressively changed up or down. They are usually away from the current strike price. As they need large price movements, profits can go beyond 100%. But such trades may not be easily available.
Types of Expiry
The expiry time is that time when we need to close our trade. The Expiry for regular options is of just one type. But in case of binary options, expiry also has its types. Flexibility is provided in selecting the expiry for our option. Expiries are classified into three categories.
- Short time – These normally expire within 5 minutes.
- Normal – Their expiry starts from 5 minutes and can go up to the end of the day. But the time needs to be set before the market closes.
- Long term – Choosing any expiry beyond the end of the day would be considered the long term. The longest possible is 12 months.
Advantages of Binary options
There are various benefits of using binary options over regular options. The main benefit is that they provide clarity on risk to reward ratio.
- Minimum risk – There is leverage to take in binary options. Factors such as slippage and price re-quotes have no effect on a binary options trade. This reduces risk in binary options to a minimum.
- Simplicity – A binary option has just one parameter. That is the direction. In addition, the trader also has the liberty to choose expiry. This can give the trade more time. It helps in reducing our losses. Whereas in other markets losses can only be controlled using a stop loss.
- Flexibility – The binary options allow us to trade various financial instruments. They are the currency, commodity, as well as indices and bonds. It not just gives the opportunity to trade but also gives traders with the knowledge of how to trade these markets.
- Higher profits – The profits per trade are higher in binary options than normal options. Some traders even offer profits up to 80% on a trade. Such profits are only possible in other conventional markets if a large sum of capital is bet in the market. Doing such a thing violates the rules of money management.
Disadvantages of Binary options
- Reduced probability of winning – While it is true that binary options give 85% profit on the trade. But the odds of succeeding in the trade are very low. In binary options, trades are more unpredictable.
- Availability of trading tools – Some brokers do not offer the necessary trading tools required in binary options. Traders who are new to the market mainly face this issue. This is changing over time as awareness of binary options is being created among traders. Brokers are coming up with attractive tools.
Hope you understood what Binary Options are. Got any questions regarding this? Shoot them in the comments below.