What Are Binary Options?

In the world of finance, binary options are an important part of any investment. Defined as an option that provides a payoff of a fixed amount on an asset, or no payoff at all, they come in two different varieties termed cash-or-nothing and asset-or-nothing. These two types differ somewhat.
1. Cash-or-nothing: This option pays a fixed amount of cash if the option expires in-the-money.
2. Asset-or-nothing: This option pays the value of the underlying security.
When someone is buying a binary option, the potential return offered is certain and known before the purchase is even made. Binary options can also be bought on any financial product, and can be bought in both directions of trade by either buying a Put/Down option or a Call/Up option. What this means is that the investor is able to go long, or they can go short, on any financial product by just buying a binary option.
Here is an example of how this works:
If a purchase is made on a binary cash-or-nothing call option on a company stock, where the stock price is struck at $100 with a payoff of $1,000, then the stock must be trading at or above $100 that amount by the maturity date of the option. If it is trading at or above $100, the investor will receive $1,000. If it is trading below $100, then nothing will be received.
Detailed Example
Here is a better example that goes into more detail to help you with understanding binary options.
A trader sees the price of a stock and believes it will close at $1.25 at 3 p.m., so he/she buys a call option on that outcome. Another trader thinks that the price will close at or below $1.25 at 3 p.m., so he/she buys a put option.
At 2 p.m., the price is $1.2490 and the trader believes it will increase, so he/she buys 10 call options at or above $1.25 at $40 each. The risk is known to the trader, and the gross profit or loss is going to be an all or nothing scenario. He/she can lose all their money in the trade, which would be $400, or they can make a profit of $1,000. If the stock trades at the right price or above it at 3 p.m., then the trader will make $600, which is their payoff minus their investment.
Other types of Binary Options
There are several other, less-used forms of binary options, including:
1. Range Binary Option: This allows traders to select a price range that the asset will trade inside of until its expiry. If the price stays within the specified range, payout is given. If it moves out of the specified range, the investment disappears.
2. One-touch Binary Option: In this type of binary option, the price only needs to touch the specified target level once before the expiry for the investor to make their money. This means that if they predict it will hit $10 by 5 p.m., and it hits $10 at 2 p.m., then falls to $1 at 5 p.m., the investor still receives their payout.
Advantages and Disadvantages
As with any other investment, there are its benefits and drawbacks.
The biggest benefit of the binary option market is that the risk is already known. It doesn’t matter how the market moves, whether in favor or against the trader. Only two outcomes are possible, either a known amount is earned or a the cost of the option is lost. Another big advantage is the fact that there are typically no fees. Binary options are also easy to employ and only one decision is needed, to determine if the asset will go up or if it will go down. Binary options also have no liquidity issues as the person trading them doesn’t own the asset, and the broker can provide many prices and expiration dates for the trader. Another benefit is that the trader can access a wide variety of asset classes in the global market.
In terms of the drawbacks, there are a few. First, the reward is always less than the risk. This means that in order to make a good amount of money, the trader must be right a high percentage of the time to cover their losses. Losing trades costs a trader more than they can make on winning trades.
Another disadvantage is the fact that outside the United States, markets for binary options are not regulated, and there is little oversight. This means that some traders may find themselves at risk of buying options from brokers who are using unscrupulous practices, but this is rare.