What are binary options? Binary options are a type of option contract that pays a fixed amount at the end of the contract if it expires ‘in the money.’ The phrase ‘in the money’ refers to the option strike price being less than the current price for a call or greater than the strike price for a put.
There are two types of binary options: a ‘cash-or-nothing’ contract or an ‘asset-or-nothing’ contract. In either case the contract pays out either a fixed amount of cash in the former or shares of stock in the latter. Binary options also go by the names all-or-nothing options, digital options, or Fixed Return Options. These are more common in European markets than in the U.S.
Binary Options have been traded OTC, Over-the-Counter, i.e. directly sold by the buyer for years. They were only approved for trading in the U.S. by the S.E.C. in 2008. They are listed on the American Stock Exchange and the Chicago Board Options Exchange (CBOE). The CBOE offers binary options on both the S&P 500 as well as the Volatility Index (The VIX). Their ticker symbols are BSZ and BVZ respectively. The strike prices are set in 5 point intervals for BSZ.
For example, if you think the EUR/USD cross will close above $1.29 and the price is currently $1.2880. If the premium at that moment is $50 and you buy 10 contracts at that price then your risk is defined as $500. Since you have 10 contracts each pip is worth $100 to you. If the EUR/USD cross closes over $1.290 then the contract would pay you $1200 (12 pips in movement to your Strike price). Subtracting out the premium of $500, your net profit would be $700 on the trade. Since this is a binary option, if the price were to move above $1.2900 it would not pay you any more money. It’s a fixed pay out that triggers once the price is reached.
Binary options create a purely fixed risk to reward ratio and since there are no liquidity concerns brokers are free to create a more flexible structure of strike prices and expiration times/dates. Contracts are not locked into being set to expire on a particular day/time. Moreover, binary options trading creates that risk/reward ratio at the time of the trade, regardless of how the price swings around.Previous Post » Stock Options Trading – Simple Strategies