What Is A Binary Option?
A binary option can best be described as a financial product where the investor stands to either receive a payout or completely lose their investment. They are a way to trade price fluctuations in a global market. The decision to either win or lose the money depends on whether the option expires while in the money.
What does Binary Options trading means? The term – in the money – refers to an option that has intrinsic value, when compared to the market price of its asset.
Binary options primarily depend on whether the proposition turns out to be a yes or a no. These options have an expiry time and date, and when they do expire a trader will make a profit if the price of its asset is on the right side of the strike price.
Binary options exercise automatically, where the gain or loss of a transaction is immediately debited or credited to the account of the trader upon expiration.
The Basics of Binary Options
To better understand how binary options work, look at the following scenario:
A trader decides to trade binary options of a Company XYZ. He has to decide whether the share price of this company will be above or below $30 on the 31st of May, 2020, at 11:00AM. The trader decides whether the price will be higher or lower.
Should the trader have chosen yes, that the price will trade above $30 by trade expiration date and time, and he is willing to bet $200 on that, and should the price be above $30 on that date and time, he will receive a payout according to the agreed upon terms.
For example, if the payout is 75%, then the binary broker will credit the trader’s account with an amount of $150. If the price traded below $30 at that expiration time and date, then the trader would lose their $200 investment. You can read more about binary options on business24-7.ae
The Difference Between Binary And Vanilla Options
A vanilla option allows the trader to buy or sell an asset at a specified price before the option expires, whereas a normal European option only allows the trader to buy or sell the asset on the date of expiration.
A vanilla option will provide the trader with potential ownership of the asset. Entering into these trades poses a fixed risk with profits varying according to how much the price of the underlying asset moves.
A binary option on the other hand does not provide the trader with the possibility of taking a position in the asset. These options have a fixed payout at expiration, with the risk limited to the amount invested. Unlike the vanilla option, the payout price or the loss incurred is not affected by movement in the asset.
Rather, the gain or loss in the trade depends on the position the asset is in on expiration. Whether it is on the correct side of the strike price. It is possible to close the binary option before it expires, however, this will reduce the amount of payout received should the option be in the money.
Binary Options and Regulation
Binary options are traded on Securities and Exchange Commission regulated platforms. With much of the trading occurring outside the United States, it may not all be totally regulated.
Unlike regulated binary options brokers, unregulated brokers do not have to meet a particular standard of quality. Thus, the potential for fraud is something a trader has to be aware of when dealing with these brokers.
Vanilla options are traded on regulated US exchanges and are thus subjected to more regulated oversight.
Real World Binary Options Example
A well-known regulated binary options exchange in the US is Nadex. Their binary options work on an exit before expiry option and a yes or no proposition. The price the binary option enters at will determine the potential profit or loss. When options enter in at $100, there is a possibility for expiration payout to be either $100 or $0.
Let’s assume Nestle stock trades at a market price of $56,65. We also assume that the binary option for this stock has a strike price of $60 and expires the next day at 3pm. The investor can buy the option at $30. Should the price of the stock expires above $60, it expires in the money and it is worth $100. Thus, the investor will make ($100-$30), which is $70.
And if the option expires out of the money, at a price below $60, the investor would lose the $30 they started with. Thus, the profit made or loss incurred always amount up to $100 with a Nadex option.
The only way to make a significant investment is to increase the amount of options traded. For instance, increasing the options to four, would increase the risk to $120 ($30×4), but the profit potential to $280 ($70×4).
Other non-Nadex binary exchanges operate in a similar fashion, although they might not necessarily be regulated the US, might often not be exited before they expire, in most cases have a fixed percentage for payouts, and might not trade in increments of $100.