Binary options don't function the same way as ordinary options, even if they carry the very same titles for instance "calls" or "puts". In their favour, their pricing and profit constituents are much less complex for the reason that time decay isn't an issue. On the negative, they're normally very short term speculative trades determined by where you anticipate the underlying to be within an intraday setting. If it's wherever you predicted, you enjoy a set profit; if it isn't, you lose most, but not your entire investment.
The word "binary" signifies "two" so this class of options is well named. There will only be two possible outcomes - you get paid or you don't. At times they're called all-or-nothing options, digital options or fixed-return-options (in the USA).
In a manner of speaking you could look at it like wagering on a thoroughbred race. The difference is, there are only two starters with this race - the first is named "up" and the second "down". If you pick the right one, you win; if not, you forfeit about 90 percent of your outlay. Binary options typically have an appealing return on risk percentage - often way higher than 50 percent and this inevitably suggests that providing you get more trades right than wrong, you're making a net gain.
Binary options may also be used for short term range trading. Instead of your objective being for the price to be above or below a particular price level, you're now speculating that the price of the underlying will trade inside a specified range during an agreed period of time. These are called "hit or miss options". The trader chooses the price range and also the timeframe and the broker then creates a price. If the price of the underlying remains within the price range during the short timeframe specified, you've got a "hit" receive a payment.
Binary Options Pricing
Like normal options, the pricing of binary options incorporates the element of implied volatility which means you'll want to analyze the price offered to make certain there is value in the binary call or put options you intend to purchase. The real key is to devise a plan which includes an appropriate return on investment for successful trades that is enough to cover the anticipated number of losses. For example, a minimum 70 percent gain on each successful trade and 10 percent loss on failed trades will mean that you need to get 6 trades out of 10 correct in order to make an overall profit. Should you accept less than 70 percent ROI then the mandatory number of profitable trades increases.
Binary options are never exercised and that means you won't be landed with the underlying financial instruments at expiration time. The outcome is really simple - you either get paid or you don't. They are usually European-style options since they will be only settled in cash at expiration. The payout is either cash-or-nothing or asset-or-nothing. In each case, you receive cash, that being the value of the asset.
Binary options can be traded on stock indexes, currency pairs or individual stocks.
Let's take a look at an example:
Assume it's 11.30am and the EUR/USD currency pair is trading at 1.3480. You feel that it will close at or above 1.3500 by 2pm today. Therefore you buy 10 binary call option contracts with this strike price, at a cost of $40 per contract = $400 cost. If the EUR/USD is at or above 1.3500 come expiration time, you receive $100 for each contract. Below that you receive nothing.
The expiration time comes and you're in luck. Your profit is $1,000 less the $400 cost of the options, ie. $600. You risked $400 and made $600 which is 150 percent return on investment. Well done!
The simplicity of binary options has made them appealing to speculative traders and their introduction in July 2008 has opened up yet one more way for you to trade options.