The binary option, (i.e., digital option, all-or-nothing), is a relatively new trading vehicle that differs from a traditional option in several ways. Originally termed an exotic option, the binary option was available only to a select few. A specified broker had to be used to trade exotic options and additional fees were charged for this privilege. However, by 2008, the Options Clearing Corporation, and then the American Stock Exchange, were both offering these options openly. Just two years later, exotic options, now termed binary options, have become a rather popular trading vehicle.
Binary options offer predetermined wins/losses and set payouts. In essence, the investor estimates if an asset will rise or fall over a discrete period of time. If the estimate is for an asset rise, a call option is made. If the estimate is for an asset fall, a put option is made. Whenever the investor’s estimate is fulfilled, he or she receives a pre-set payout. When the investor’s estimate is not fulfilled, he or she suffers an investment loss.
With binary options, there is always a pre-set payout percentage for each correct option investment made, and it is usually in the amount of 70-80% of the original investment. There is also a pre-set loss percentage. Both of these percentages will differ for every asset as well as time span. Incidentally, the time span through which the asset rises or falls is termed the option expiration. So, if an investor creates an option and this option expires “in-the-money”, the investor earns a pre-set payout percentage from his/her original investment. If an option expires “out-of-the-money”, the investor loses a pre-set payout percentage from his/her original investment too. As opposed to traditional options, binary options don’t depend on how much they are either in- or out-of-the-money. Also, almost any market asset can become a binary option, whether it is composed of stocks, commodities, market indices, or currencies.
Unlike traditional options, binary options don’t operate on set prices; the investor simply decides how much money to invest when the option is generated. Expiry times on binary options can vary incredibly, lasting anywhere from one month to one day to even one hour. Because binary options can have a very limited life span, this means that they might be placed several times a day (i.e., day-traded).
Consider the following example of a typical binary option investment:
Around 11 AM in the morning, an investor sees that wheat is estimated to drop in price by the end of the day. She logs into her options trading account and also finds out that the payout for being “in-the-money” on wheat is 75% while the loss is 90%. After doing some additional research, this investor invests $2,000 on a put option for wheat set to expire at 3 PM.
By the time 2 PM has arrived, wheat has fallen from $4.65 to $4.6109. At the end of the day, wheat is trading at $4.5923. Because this investor’s put option expired “in-the-money”, she receives 75%, or a grand total of $3,500, back from her original investment. However, had wheat rose to $4.6501 or higher, she would’ve received back a grand total of only $200 from her original investment- a loss of $1,800.
Binary options have become quite popular since becoming mainstream in 2010. Part of the reason for their popularity is their overall simplicity; the option price goes either up or down. Also, binary options offer limited risk; traditional options, which have no set parameters, can result in huge gains or losses on the original investment.
Investors can also choose to hedge binary options in order to limit their potential losses. Going back to the example illustrated earlier, if the investor sees that wheat has fallen from $4.65 to only $4.6498, she may become concerned that it will rebound by the end of the day. Therefore, she may wish to place a second $2,000 call option on wheat with a strike point of $4.6501. That way, if wheat rises to $4.6501 or higher, she will have lost money on her put option but made money on her call option, resulting in a net loss of only $300 instead of $1,800 ($1,800 loss + $1,500 gain = $300 loss).
In addition to puts and calls, an investor can also conduct range and volatility trading with binary options. As an example, an investor could consider that the future price of gold will be stable and so purchase an “In” the range option. Another investor might see gold as volatile and purchase an “Out” of the range option. Both investors will need to establish a time frame within which the price of gold is expected to be stable or volatile.
Incidentally, the prices determined to be stable or volatile are predetermined by the broker and are called tunnel prices. If a given investment stays within the parameters of those tunnel prices and expires “in-the-money”, it will receive the pre-set payout. If a given investment does not stay within the tunnel parameters, it will expire “out-of-the-money” and will suffer a loss.
Binary options do carry an element of risk that is significantly higher than that found in regular stock trading. However, binary options are much less risky than traditional options. Investors who wish to invest in binary options should research a finite number of assets and follow these assets for at least six months. Making practice puts and calls is recommended, and some options accounts even offer an options simulator that allows the investor an opportunity to become comfortable with options trading before making such investments for real.
