What are Binary Options

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Binary Option

What is a Binary Option?

A binary option is a financial product where the buyer receives a payout or loses their investment, based on if the option expires in the money. Binary options depend on the outcome of a “yes or no” proposition, hence the name “binary.” Binary options have an expiry date and/or time. At the time of expiry, the price of the underlying asset must be on the correct side of the strike price (based on the trade taken) for the trader to make a profit.

A binary option automatically exercises, meaning the gain or loss on the trade is automatically credited or debited to the trader’s account when the option expires.

Binary Options Outside the US

Basics of a Binary Option

A binary option may be as simple as whether the share price of ABC will be above $25 on April 22, 2020, at 10:45 a.m. The trader makes a decision, either yes (it will be higher) or no (it will be lower).

Let’s say the trader thinks the price will be trading above $25, on that date and time, and is willing to bet $100 on it. If ABC shares trade above $25 at that date and time, the trader receives a payout per the terms agreed. For example, if the payout was 70%, the binary broker credits the trader’s account with $70.

If the price trades below $25 at that date and time, the trader was wrong and loses their $100 investment in the trade.

Key Takeaways

  • Binary options depend on the outcome of a “yes or no” proposition.
  • Traders receive a payout if the binary option expires in the money and incur a loss if it expires out of the money.
  • Binary options set a fixed payout and loss amount.
  • Binary options don’t allow traders to take a position in the underlying security.
  • Most binary options trading occurs outside the United States.

Difference Between Binary and Vanilla Options

A vanilla American option gives the holder the right to buy or sell an underlying asset at a specified price before the expiration date of the option. A European option is the same, except traders can only exercise that right on the expiration date. Vanilla options, or just “options,” provide the buyer with potential ownership of the underlying asset. When buying these options, traders have fixed risk, but profits vary depending on how far the price of the underlying asset moves.

Binary options differ in that they don’t provide the possibility of taking a position in the underlying asset. Binary options typically specify a fixed maximum payout, while maximum risk is limited to the amount invested in the option. Movement in the underlying asset doesn’t affect the payout received or loss incurred.

The profit or loss depends on whether the price of the underlying is on the correct side of the strike price. Some binary options can be closed before expiration, although this typically reduces the payout received (if the option is in the money).

Binary Options and Regulation

Binary options occasionally trade on platforms regulated by the Securities and Exchange Commission (SEC) and other regulatory agencies, but most binary options trading occurs outside the United States and may not be regulated. Unregulated binary options brokers don’t have to meet a particular standard; therefore, investors should be wary of the potential for fraud. Conversely, vanilla options trade on regulated U.S. exchanges and are subject to greater oversight.

Real World Binary Options Example

Nadex is a regulated binary options exchange in the United States. Nadex binary options are based on a “yes or no” proposition and allow traders to exit before expiry. The binary option’s entry price indicates the potential profit or loss, with all options expiring worth $100 or $0.

Let’s assume stock Colgate-Palmolive Co. (CL) is currently trading at $64.75. A binary option has a strike price of $65 and expires tomorrow at 12 p.m. The trader can buy the option for $40. If the price of the stock finishes above $65, the option expires in the money and is worth $100. The trader makes $60 ($100 – $40).

If the option expires and the price of the Colgate is below $65 (out of the money), the trader loses the $40 they put into the option. The potential profit and loss, combined, always equals $100 with a Nadex binary option.

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If the trader wanted to make a more significant investment, he or she could change the number of options traded. For example, selecting three contracts, in this case, would up the risk to $120, and increase the profit potential to $180.

Non-Nadex binary options are similar, except they typically aren’t regulated in the United States, often can’t be exited before expiry, usually have fixed percentage payout for wins (whereas Nadex payouts fluctuate based on the price paid for the option) and may not trade in $100 increments.

A Guide to Trading Binary Options in the U.S.

Binary options are financial options that come with one of two payoff options: a fixed amount or nothing at all. That’s why they’re called binary options—because there is no other settlement possible. The premise behind a binary option is a simple yes or no proposition: Will an underlying asset be above a certain price at a certain time?

Traders place trades based on whether they believe the answer is yes or no, making it one of the simplest financial assets to trade. This simplicity has resulted in broad appeal among traders and newcomers to the financial markets. As simple as it may seem, traders should fully understand how binary options work, what markets and time frames they can trade with binary options, advantages, and disadvantages of these products, and which companies are legally authorized to provide binary options to U.S. residents.

Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative—but only if the trader fully understands the two potential outcomes of these exotic options.

Now that you know some of the basics, read on to find out more about binary options, how they operate, and how you can trade them in the United States.

U.S. Binary Options Explained

Binary options provide a way to trade markets with capped risk and capped profit potential, based on a yes or no proposition.

Let’s take the following question as an example: Will the price of gold be above $1,250 at 1:30 p.m. today?

If you believe it will be, you buy the binary option. If you think gold will be below $1,250 at 1:30 p.m., then you sell this binary option. The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.

The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then, you will pay $44.50. If you decide to sell right then, you’ll sell at $42.50.

Let’s assume you decide to buy at $44.50. If at 1:30 p.m. the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100—$44.50 = $55.50 (minus fees). This is called being in the money. But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This called out of the money.

The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss, compared to letting it expire out of the money.

A Zero-Sum Game

Eventually, every option settles at $100 or $0—$100 if the binary option proposition is true and $0 if it turns out to be false. Thus, each binary option has a total value potential of $100, and it is a zero-sum game—what you make, someone else loses, and what you lose, someone else makes.

Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, and so the trade costs you $44.50. The person who sold to you has a maximum risk of $55.50 if the option settles at $100—$100 – $44.50 = $55.50.

A trader may purchase multiple contracts if desired. Here’s another example:

  • NASDAQ US Tech 100 index > $3,784 (11 a.m.).

The current bid and offer are $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80, or place a bid at a lower price and hope someone sells to you at that price. If you think the index will be below $3,784 at that time, you sell at $74.00, or place an offer above that price and hope someone buys it from you.

You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the strike price) by 11 a.m. And if you really like the trade, you can sell (or buy) multiple contracts.

Figure 1 shows a trade to sell five contracts (size) at $74.00. The Nadex platform automatically calculates your maximum loss and gain when you create an order, called a ticket.

Nadex Trade Ticket with Max Profit and Max Loss (Figure 1)

What are Binary Options and How Do They Work?

What is a binary option?

A binary option is a financial instrument based on a simple yes or no question where the payoff is a fixed amount or nothing at all.

This means binary options offer defined risk and clear outcomes on every trade.

Each binary option trade starts with a question – will this market be above this price at this time? If the answer is yes, you can buy the option. If it’s no then you can sell the option.

The price of a binary is always between $0 and $100, and just like in other markets, there is a bid and ask price.

The binary options we offer are always built the same way. Each trade is easy to understand.

If you think about it, binary options reflect the way we think about things in our daily life. Things either happen or they don’t. With a binary option, payouts reflect that and are always all or nothing at expiration. You’ll find we like to keep trading simple.

You can also close a position early to lock in profits or limit losses.

As an active trader, we know you are busy scanning markets each day. You are dealing with complexity all the time. The last thing you need is to be slowed down with more complications and hard to understand details with a brokerage.

When you trade, we know you want to focus on the market and your position, not on a series of unnecessarily complicated products.

So we built an innovative full service exchange to trade binary options that lets you do just that.

How do binary options work?

There are three concepts to learning more about how binary options work; the underlying market, strike price and time to expiration.

Become familiar with those three concepts and you’ll understand the basics of binary options.

Let’s walk through the three parts of each binary option trade:

With binary options the amount you pay is the maximum you can lose. Because of that we say your risk is capped.

Maybe you don’t want to wait until expiration. You can place an order to close your position to limit loss or lock in profit early.

Along with offering clear outcomes and defined risk, we also designed our binary options to work in a way that offers unique leverage that enables opportunities to profit even from small market movements.

1 The first step is to pick the assets or event you want to trade. Each one is based on an underlying market and your trade is based on that underlying markets price movement.

2 Then you want to find a strike price that works for you. The strike is the price level you think the market will be above or below at expiration.

3 When opening a trade you will select an expiration day and time. The expiration is the moment of truth traders live for. This is when trading is over and the value of your binary option is determined.

How risky are binary options?

You always know your binary option risk reward ratio before you enter into a new trade. Your trade is fully paid for up front, which means you will never lose more than you pay. You always know exactly what you have at risk.

Trading also offers the opportunity to profit. Just like you know what you have at risk, you will enter each trade knowing your maximum potential reward.

We’re serious about helping you understand and limit your risk. Our goal is to let you define and understand it clearly and upfront on every trade.

It’s why we’ve worked to design and offer an innovative way to define and cap risk while also providing an affordable way to trade.

You can start with one contract at a time for less than $100, and decide your maximum risk and reward up front when you set up the trade.

Here’s how that works:

If you buy a binary option contract for $30, hoping to have it end at $100, your profit target is $70. This is $100 less your $30 investment. A loss would never be more than $30 no matter how much the market moves.

We think that hard to understand margin requirements, complicated fees and confusing payout structures can make trading riskier than it needs to be.

You can make those things part of your past by trading binary options with us.

How are binary options regulated in the US?

Binary options are legal and available to trade in the US only on a Commodity Futures Trading Commission (CFTC) regulated United States exchange.

We are a full service exchange located in the heart of Chicago’s financial district and we are regulated by the CFTC.

As the leading United States based binary options and spreads exchange, we are proud to say we are designated by the CFTC as a Designated Contract Market and Derivatives Clearing Organization.

What this means for you is we are a well-regulated and leading binary options exchange.

Our role as the leading US based binary options exchange is to match buyers and sellers in a fair, accurate and secure way.

That way you can trade multiple global markets with us from one account knowing your trades are fair and your money is safe.

Binary options trading example.

Let’s walk through a trade on the EUR/USD currency pair.

Here is how the outcomes work at expiration:

  1. If the market is at or below 1.1600 at 3AM ET the seller will get the $100 payout.
  2. But if the market is one tick or more above 1.1600, you get the full payout as the buyer.

If you don’t want to wait until expiration, you can close your position at the current market price. Your profit or loss in that case is the difference between your entry and exit prices.

Each binary option reflects a question. In this case, the question is, will EUR/USD be above 1.16?

We show that as EUR/USD > 1.1600

In this example, the option has 4 hours til expiration and it’s 11pm.

If you think EUR/USD is going to be above $1.16 at 3AM, then you would then buy the binary.

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