Constituents of a binary option contract

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Constituents Of A Binary Option Contract

In a binary options trade, once a trader selects a suitable asset (equity, commodity, currency or index) and forecasts the probable direction of price movement, a call or put option should be purchased. To do so, a trader should have a clear understanding of the technical lingo, which is unique to options trading.

Asset: Any item, which has a money value, is referred to as an asset. An asset can be tangible or intangible. As far as binary options trading is concerned, the asset can be an equity (common stock of a company), commodity (precious metal, wheat, rice, sugar, cotton, zinc, lead, etc.,), index (Dow Jones, Nasdaq, FTSE, DAX, etc.,) or currency pair (USD/CHF, EUR/USD, AUD/USD, NZD/USD, etc.,).

Expiry: It is the time for which a contract remains valid. A contract becomes void as soon as the expiry time passes by. In the case of a binary options trade, the value of an asset is calculated based on the existing price at the end of last second of the expiry time. For example, if the expiry time is 60 minutes, then the prevailing price at the end of 59 minutes and 59 seconds is used to determine the outcome of a trade.

Strike price: It is the reference price based on which the profit or loss is calculated in a binary options trade. For example, let us assume that a binary options trader expects the price of crude, which is currently trading at $35, to go up. He proceeds to purchase a binary call option contract of crude priced at $40. Then the strike price for this trade is $40. At expiry, if the price of crude is $40.01 or more, then the buyer (option holder) will receive the stipulated amount.

Option Alpha

Premium: It is the difference between the prevailing market price and the price paid to the writer of an options contract. It is a term regularly used in vanilla options. The term can be understood clearly from the following example:

A trader anticipates a decline in the price of Apple (AAPL) stock to $95. Let the prevailing share price of Apple is $101.15.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

A vanilla options trader would purchase a put option contract with strike price of $95. Let the premium for the strike price is $0.10. Thus, for buying 20 lots (1000) of Apple put option contract, the investment required is $100 ($0.10 * 1000). Let the expiry period is one month. If the traded price of Apple is $94 at expiry, the premium would have risen to approximately $1. The trader can sell the put option contract for a profit of $100.

If the traded price of Apple is $94.99, then, theoretically, the premium would be only around a cent. Thus, after deducting the exchange related charges, the buyer (options holder) would end up in a small loss.

For the same scenario, a binary options trader would decide the investment first. Let us assume that the binary options trader is willing to take a risk of $100. The binary options trader would then proceed to purchase a binary put option contract with a strike price of $95 from a binary broker offering a payout of 92%. Let the expiry date is one month. If Apple trades at even $94.99 at expiry, then the trader’s account will be credited with $192 [$100 (investment) + $92 (payout).

In-the-money: An in-the-money option contract will have a value more than $0 at expiry. For example, if a binary option trader has bought a put option contract for crude with a strike price of $35, then the contract is said to be in-the-money, if the price of crude is at least a notch below $35 at expiry. To put it simpler, a profitable trade is usually referred to as in-the-money contract.

Out-of-money: At expiry, an out-of-money option contract will have no value. For example, if a binary option trader has bought a put option contract for crude with a strike price of $35, then the contract is said to be out-of-money, if the price of crude is at least a notch above $35 at expiry. To put it simpler, a loss making trade is generally referred to as out-of-money trade.

Binary Options and Their Unique Characteristics

The word binary means two. A binary option contract is a simple derivative contract with only two possible outcomes.

Depending on the prevailing price of the asset at expiry, the trader either loses his entire investment or receives a pre-determined profit percentage.

Thus, binary option contracts are also referred to as fixed return options (FRO) or all-or-nothing contracts.

The value of a vanilla or regular option traded on an exchange keeps changing in accordance with the changes in the price of the underlying asset.

On the other hand, the value of a binary option contract is determined only at the time of expiry. It can be understood by a simple example provided below:

landsharkanalytics

Let us assume that a buyer purchases a call option contract for gold. Let the price of gold at the time of purchasing the contract is $1200 per ounce.

Let us assume that the expiry time is one day.

At expiry, if the price is above $1200, then the binary call option contract will result in a profit. The holder of the binary contract will receive up to 92% (depending on the broker) of the invested amount. If the price is below $1200, then the binary call option contract will expire worthless. The holder of the contract will lose his entire investment. The inverse is true in the case of put option contract.

As it can be understood, there is no way to exit (some brokers offer such a facility, which we can discuss in later topics) in between.

In the case of vanilla options, which are traded on an exchange, the value keeps changing and a trader can exit any time in between. However, the difference between the price of the underlying asset at the time of entry and exit determines the value of a vanilla option and the corresponding profit or loss. On the other hand, a binary option holder will receive the pre-determined payout even if the price has moved only a few notches favourably in the direction of trade.

The following are the most important differences between vanilla and binary options contract:

Counter parties: The binary options contract is an Over-The-Counter (OTC) product. It is not traded in any exchange (apart from Nadex which offers a totally different structure). The contracts are offered by brokers who act as the sellers (writers). The retail trader will be the buyer (holder) of the contract. In the case of vanilla options, the exchange facilitates or provides a platform for two parties to buy (holder) and sell (writer) an option contract. As it can be understood, the broker (market maker as they are called technically) bears the risk by writing the contract in the case of binary options. In the case of vanilla options, the exchange simply supervises the trade and does not bear any price movement related risks.

Expiry: The binary option contracts are created by the brokers without the involvement of the regulatory bodies. Thus, binary option brokers offer a wide range of expiry periods starting from 30seconds. On the other hand, the structure of a vanilla option contract is determined by the exchange and regulatory bodies. Thus, generally, the vanilla contracts only have monthly expiries. Being an OTC market, the binary brokers are at full liberty to customize products to suit the demand of individual traders. It is not so in the case of vanilla options contract.

Range of options contract: The binary brokers not only offer contracts with multiple expiry periods, but also modifications in the settlement process. For example, in the case of a one touch option contract, as long as the price touches a specific level any time before the expiry of the contract, the trader will receive a fixed amount as profits. However, the vanilla option contracts follow the same standard structure.

Payout: As long as the price keeps moving in the direction of trade, the value of a vanilla option contract will increase. Thus, theoretically, the profits can be unlimited. However, sudden reversals before the expiry time will erode most of the gains. In the case of binary options contract, the trader will receive a fixed profit irrespective of the quantum of price movement in the direction of trade. For example, if a binary options trader has bought a put option contract for gold at $1200, then as long as the price trades below $1200 at expiry, the trader will bag the entire amount allotted as profit. Irrespective of whether the price trades at $1199.99 or $1100, the trader would receive the same fixed percentage guaranteed at the time of entering the contract. In the case of vanilla options, practically, the trader would only incur a loss if the price trades at $1199.99. The reason is that value of vanilla option contracts suffer from time decay. Binary option contracts do not face such an issue.

Other charges: Binary option brokers do not charge any other fees for executing a trade. On the other hand, vanilla option trades would involve exchange related fees and other taxes imposed by the state where the exchange is located. The binary options broker, being a counter party (writer) to all the trades, receives the entire investment of a trader as profit whenever an option holder loses the trade. Thus, the binary options broker does not levy extra charges for executing a trade. Reputed binary options broker mitigates risk through hedging and sophisticated algorithms. This protects them from losing a large amount of money when a trader wins consistently.

Exercise time and rights: The binary option contracts are purely speculative contracts. Thus, the buyer (holder) of the contract will not have any rights to exercise (no demand can be made to buy or sell the underlying asset at the price mentioned in the contract). The contract simply ends in a profit or loss at expiry. The market maker or broker bears the entire risk. On the other hand, vanilla options traded through an exchange offer exercising rights to a trader. The trader can claim his right to buy or sell the underlying asset at or before the expiry.

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.

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.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Good for Beginners!
    Free Education + Free Demo Account!
    Get Your Sign-Up Bonus Now!

  • Binomo
    Binomo

    Only For Experienced Traders!

Like this post? Please share to your friends:
Binary Options Trading
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: