A binary option is a derivative financial product in which the payoff for the buyer is a fixed monetary amount if the option expires “in-the-money,” or nothing at all if the option expires “out-of-the-money.”
Binary options are one of the simplest financial assets to trade, which has resulted in broad appeal amongst traders and newcomers in the financial markets. In this article, readers will gain a basic understanding of binary options trading and how it can be used as another tool in an investing playbook.
The success of a binary option is based on a simple yes or no proposition: will the underlying asset be above a certain price at an expiration date? If an investor thinks the answer is yes, then he would buy a binary option. If an investor thinks the answer is no, then he would sell a binary option.
At the expiration date, whoever is correct, whether that be the buyer or seller, will get a $100 payout. Whoever is wrong, gets nothing in return.
Binary options can be traded on an exchange known as the Nadex. The Nadex is the first and largest U.S. exchange focused on binary options. The Nadex allows investors to trade binary options for underlying assets such as stock indices, forex pairs, or commodities.
Let’s look at an example of a binary option.
Assume a stock index, labeled as ABC, is trading at $50. A binary option has a strike price of $52 that expires in three days at noon. Suppose an investor buys the binary option for $20.
If the price of ABC closes above $52 at expiration, then the option expires “in-the-money” and is worth $100. The buyer will reap a profit of $80 (100 – 20).
If the price of ABC closes below $52 at expiration, then the option expires worthless. The buyer loses the $20 he paid for the option.
Binary options are simple and relatively safe investments. The risk and reward on binary options is capped. It is not possible to lose more than the cost of the trade. On the other end, the most a binary option can be worth is $100.
Investors with little trading capital and experience can use binary options as a way of gaining knowledge in the financial markets and potentially earning a profit.