Known by a variety of names such as ‘fixed return options’, ‘digital options’, ‘one touch options’, or ‘all-or-nothing options’, binary options are a type of derivative option in which a trader takes a simple yes or no position on the price movement of an underlying asset such as FOREX, commodities, share or index prices.
With only two possible outcomes; win or lose – binary option traders attempt to predict whether the price of an underlying asset will be trading above or below a specific price (the strike price) at a specified time in the future – known as the expiry – for which the trader will earn a fixed amount if the trade expires in their favour or nothing at all.
Binary options are classified as an exotic option, that is – an option that differs in structure from an American or European option. They are considered a high risk, speculative investment.show more
Dating back to as early as 1974, a quasi-style binary option was available only to banks, institutional investors and high net-worth clients as an Over-the-Counter (OTC) semi-official investment product. In 2008 the US Securities and Exchange Commission (SEC) legalized the trading of binary options on major exchanges certifying them as a tradeable financial instrument and in the same year, the Chicago Board of Exchange (CBOE) introduced the binary option as a tradeable asset.
Today, binary options are available for trade by speculative and institutional investors across almost all tradable financial assets with a variety of contract types and expiration periods ranging from just one-minute to one-year.
A binary options contract has a number of distinct elements: cash settlement, call or put options, expiry and settlement price.
There are two methods of settlement for binary options trades: cash or asset settlement. The large majority of binary options trades are cash settled.
Also known as cash-or-nothing options, when a cash settled binary option contract expires ‘in the money’ (ITM), a fixed amount of cash is paid to the trader. If that binary option contract expires ‘out of the money’ (OTM), the trader receives nothing at all and the trade is a losing trade.
Asset settled binary options contracts are settled with the underlying asset. These binary option contracts are much less common.
Call or Put
Similar to ‘long’ or ‘short’ positions held in the stock or FOREX market, binary options transactions are either ‘call’ or ‘put’ depending on a trader’s price bias of the underlying asset.
A call binary options contract is taken if a trader anticipates a price rise of the underlying asset. That is, if the assets value is higher than the strike price at expiry, the binary options trade will expire ITM. If the underlying assets price is below the strike price at expiry, the binary option will expire OTM.
A put binary options contract is taken if a trader foresees a price decline of the underlying asset. That is, if the assets value is lower than its strike price at expiry, the binary options trade will expire ITM. If the underlying assets price is above the strike price at expiry, the binary option is OTM.
Integral to binary options trading is the expiration time. Depending on the broker, ‘expiry’ is either the amount of time until the binary options contract expires, or the actual time in which the binary options contract expires. Regardless of the characterisation, the expiration period of a binary options contract may be short (1 to 5-minutes), medium (5-minutes to 2-hours) or long-term contracts which have an expiry of longer than 2-hours (up to one-year).
Binary options traders also have the possibility to close out positions early – when the expiry time or date has not yet been reached. A lower payout amount is paid to the trader if the ITM position is closed early with the lower amount dependent on the current underlying price and time left until expiry.
Expiration is an important factor for binary options traders to consider. Choosing the optimal expiry period can depend on a trader’s price expectation of the underlying asset and the payout rate risk factor and should be carefully considered before entering a binary options trade.
The settlement price or payout for a binary options trade is listed by the broker as a percentage value indicating how much a trader will profit if the binary options trade expires ITM. Although different binary options contracts attract varying payout rates, generally the payout amount is between 65 and 90-percent. The final settlement amount for an ITM trade is the sum of the profit percentage plus the initial investment amount.
If a trade expires OTM, the trader will receive a settlement amount of zero.
EXAMPLE: If a trader invests $100 in a binary options trade which has a payout of 75-percent, if the trade expires ITM, the trader will receive a settlement amount of $100 (their initial investment) plus $75 (the payout percentage). If the trade expire OTM, the trader will receive zero.
Depending on the broker, binary options trading is available on almost any tradeable global financial market. The underlying asset can include commodities such as gold or oil, stocks, currency pairs or indices such as ASX200 or Nikkei 225.
Binary options traders select their market depending on volatility, liquidity and/or trading times.
Depending on the broker, a binary options trader has a number of trade types available to them.
Based simply on a trader’s anticipation of price trading higher or lower at expiry, the High/Low trade is the most basic type of binary option and favoured by new binary options traders.
Depending on the underlying asset and the strike price of a High/Low trade, if the trader believes price will be trading above the strike price at expiry, a call option (also referred to as an ‘up’ trade depending on the broker) will be taken. A put option (or ‘down’ trade) will be executed if the trader foresees price trading below the strike price at expiration.
Expiration times for a High/Low binary option are dependent on the broker, but generally vary in timeframe from 5 to 15-minute expiry. If at expiry, the trader is correct about price and the underlying asset is trading at level anticipated, the High/Low binary option will expire ITM.
One Touch/No Touch
For more experienced traders, One Touch/No Touch binary option assigns a price target and an expiration time to the trade.
A One Touch binary options requires that price touches an assigned level during the active trade period. If price does touch the target, the binary option trade will expire ITM. If price does not touch the assigned price, the One Touch binary option will expire OTM.
A No Touch binary option requires the opposite, that price does not touch the assigned target during the trade period. If price does not touch the traded level, the binary option will expire ITM. If price does touch the assigned price, the No Touch binary option will expire OTM.
A Boundary binary option is also known as a Range trade and is used when a trader anticipates price trading in a channel bound by upper and lower support and resistance levels. Considered a Double No Touch trade, price is required to stay within the assigned bounds for the period up until expiry.
Offering binary option trader’s the opportunity to profit in flat market conditions, a Boundary trade will expire ITM if price remains range bound. If price breaches assigned levels during the trade period, the binary option will expire OTM.
Considered a more complex binary options trade and often advertised offering payout returns of more than 1000-percent, a Ladder offers a trader the opportunity to profit at multiple price levels by pre-assigning a range of given strike prices and expiration times as targets during the trade period. While strike prices for the Ladder trade may be fixed at equal or arbitrary price intervals above or below the opening price, to maximise profits, consecutively assigned price levels must be touched before individual expiry times are reached in order for the trade to expire ITM.
Unique to the Ladder trade, partial profits can be collected each time price touches an assigned level before expiration of that Ladder interval.
Binary option Pair trading requires a trader to anticipate the relative performance of two underlying assets who compete in price to outperform each other. A Pairs trader attempts to identify which asset will be trading higher (or lower) at expiry.
If the trader identifies the correct asset (of the pair), the trade will expire ITM. If the alternate asset in the pair is trading higher (or lower), the trade expires OTM.
Binary Options Brokers
Not all binary options brokers comply with financial regulatory, compliance and licensing requirements of individual countries. This is because binary options trading platforms are internet based and can be unregulated. Before opening an account and depositing investment funds, binary options traders should visit the website of local financial regulatory organisation to search for approved binary option brokers in their country.