Binary options are a relatively new investment type which is known by several names. Whatever the nomenclature (fixed odds, digital options, all-or-none or fixed return options), the meaning is the same: a trade type where a trader aims to benefit from a contract in which he or she is paid for determining if one out of two possible trade outcomes is correct.
The phrase binary option also gives us a clue as to what this investment type is all about.
- Binary options literally mean “two options”.
- Fixed return options means that what the trader gets as returns for the trade is fixed, irrespective of whether the asset has gained 100 pips, 1000 pips or just one pip according to the chosen option.
- All-or-none means that the trader either gains the entire amount due to be paid for the trade if the chosen option is correct, or gets nothing if the trade outcome is a loss.
- Fixed odds option means that the chances of winning or losing are usually not variable (although this is starting to change as we shall soon explain).
- Digital options refer to the online traded nature of the options contracts, unlike the conventional options which are traded on the floors of the exchanges.
Components of a Binary Options Trade
A typical binary options trade has several components.
- The trade contract
- The traded asset
- The strike price
- The expiry time
Every binary options trade has a contract, a traded asset that could be a currency pair, a commodity (e.g. gold, silver, crude oil), a stock index (Dow, CAC40 or NASDAQ), or a stock (e.g. BNP Paribas, Coca-Cola or HSBC Holdings). Every trade also has a strike price, which is the benchmark price on which the asset’s behavior according to the trade contract specifications is measured. Finally, all binary option trades expire, and so a time limit is created for the trade’s lifetime (the expiry time).
Types of Binary Options Trades
Unlike other conventional markets, and perhaps a bit similarly to the conventional options market, binary options consist of several trade types. Each trade always has two possible outcomes for the trade, in keeping with the binary nature of the option. Since there are several brokers, each with their own trade types, it is pertinent to state that what trade types are available will differ from broker to broker. In a nutshell, these are the trade types a trader will expect to encounter.
This contract is strictly direction-based and will test the trader’s ability to determine of the asset will head upwards or downwards. Usually a benchmark price, also known as the strike price, is set. It is the relationship of the price action to this strike price that is used in gauging the trade outcome. Therefore, the trade outcome is determined depending on whether the trader chose an outcome for the asset price being higher than the strike price (HIGH) when the trade expires, or being lower than the strike price on expiry (LOW).
Two variants of this trade type exist, and are basically differentiated on whether the strike price is automatically set by the broker as market price, or whether the strike price is arbitrarily set by the trader or broker. The platform used will also determine what nomenclature is used to describe the trade type, hence we see names like Higher/Lower, Up/Down, Above/Below, Call/Put or Rise/Fall being used interchangeably.
Also known as the range option, boundary option or tunnel option in some cases, the In/Out option uses two strike prices located above and below the market price as the boundaries of the trade. The asset is then expected to either touch any of the boundaries or stay within the boundaries (IN) or breakout of the price barriers to the upside or downside (OUT). The Tech Financial platform brokers have also added a new variation to this trade which retains the essential components of the trade, but have added a compulsory one-week expiry as well as setting the boundaries far apart, thus providing an opportunity to earn up to 500% payout with the ambitious targets. This variation is known as the High Yield Boundary.
Using s pre-set strike price, it is also possible to set a trade where the outcome will depend on whether the asset price movements will touch the strike price level or fail to touch it within the allotted trade time.
There are other trade types which are essentially variations of the main trade types. Thus the time-based contracts (60 seconds, 120 seconds, 5 minutes), custom-expiry trades (OptionBuilder) and others like the paired options, also exist as ways to trade binary options.
A trade is setup by choosing an asset to trade, deciding on how much is to be invested in the trade, choosing a trade type, setting an expiry and executing the trade. If the outcome is good, the trader gets back his initial capital PLUS the profit for the trade. This is collectively called the PAYOUT. If the trade outcome is a loss, the trader loses the entire invested amount.