What Are Binary Options? | An Explanation
What are binary options? Binary options provide traders a way to bet on the direction that various financial products will trade within a specified period of time, which could include a time limit of hours, days, or weeks. The financial products that binary options are written against include specific stocks, exchange traded funds (ETFs), stock market indexes, currencies, and commodities. If a trader buys a binary option, it will pay a predetermined limited payout, if the price of the financial product that the option is written against is exceeded either to upside for a long binary options bet or the downside for a short binary options bet. A binary option expires worthless if the option’s target price is not exceeded when the option reaches its expiration time.
Binary options are also known as “all or nothing options,” since they either pay their full pre-determined amount or they pay nothing at all, depending upon the price of the underlying financial product upon option expiration. Traditional options, which are the other kinds of options that can be traded, pay out at various levels if the price of the underlying financial product exceeds the option’s target price upon option expiration. Traditional options have much greater reward potential than binary options, but are also more difficult to trade and harder to understand.
While many individual investors have trouble understanding the often complicated options trading strategies that professional traders use when trading traditional options, binary options offer a simple way to place a bet on the movement of stocks and other financial products. A binary option either exceeds the target price at the end of the specified expiration time that the binary option is written for and pay the amount advertised or it does not reach the target price and expires worthless.
The casino game craps provides a good example regarding how binary options work. While craps has a myriad of complicated bets that many inexperienced players do not fully understand, one can place a simple bet that the thrower of the dice will either succeed “pass” or not succeed “no pass”. Binary options operate in the same manner. A binary options buyer is betting that a financial product will succeed at reaching a target price before the expiration date and time.
How Binary Options Are Traded and How Money Is Made Trading Them
To understand the answer to the question “What Are Binary Options?” take a look at an example of a binary options trade.
If a trader expects Apple Inc’s stock (AAPL) to close above $500 per share at the end of a trading session because Apple has a new iPhone product rollout during the afternoon, they might buy ten binary cash call options to try to make money on an anticipated price spike in AAPL above $500 per share. The ten binary cash call options would have a strike price of at $500 at the end of the regular trading session, with a hypothetical payout of $100 on each option, if the strike price is exceeded at the time of option expiration. The ten binary cash call options would hypothetically cost $30 each, or a total of $300 to establish the binary options trade.
If AAPL closes at the end regular trading below the $500 per share strike price, the ten binary cash call options would expire worthless, and the purchaser of the options would lose the $300 that was spent buying the options. If AAPL closes at the end of regular trading above the $500 per share strike price, the ten binary cash call options would pay $100 each, or a total of $1,000, which would result in a net gain of $700 (minus any commissions paid) for the purchaser of the options ($1,000 payout minus the $300 spent purchasing the binary options). This binary option trade could also be made on the short side by purchasing binary cash put options on AAPL’s stock, if one believes AAPL’s price will close below $500 per share at the end of the regular trading session.
Binary options are essentially short-term bets on the closing price of various financial products that provide specific payouts, if the strike price is exceed at the time of option expiration. Some traders prefer binary options over traditional options because the amount of money that can be made from a binary options trade can be quantified when the options are purchased. Binary options either pay a specified amount or they don’t, based on the underlying financial product’s price at the time of options expiration, whereas traditional options could have a range of profit amounts, depending upon the price of the underlying financial products at the time of options expiration.