Binary Option: Definition, How They Trade, and Example

Definition

A Binary Option is a type of financial instrument that offers a fixed payout or none at all, depending on if a certain condition is met when the option expires. It is called ‘binary’ because there can be only two outcomes – win or lose. For example, a trader can predict whether the price of a specific asset will be above or below a certain value at a specified time, and if the prediction is correct they receive the predetermined payout, if not, they lose their investment.

Phonetic

“Binary Option” in phonetics is: /ˈbʌɪnəri ˈɒpʃən/.”Definition, How They Trade, and Example” in phonetics is: /ˌdɛfɪˈnɪʃən, haʊ ðeɪ treɪd, ænd ɪgˈzɑːmpl/.

Key Takeaways

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1. Definition: Binary options are financial derivatives that enable traders to place bets on whether the price of an asset, such as a stock, a currency pair, or a commodity, will rise or fall over a specific time period. These options get their name from the fact that there are only two possible outcomes: the trader either wins a fixed profit or loses their entire investment.
2. How They Trade: Trading binary options requires a broker. Traders predict whether the price of a specific asset will be higher or lower than a certain price at a set time. If the trader predicts correctly, they earn a profit; if not, they lose their initial stake. The possible payouts, expiry time, risks, and potential return are known upfront.
3. Example: An example of a binary option trade can be this: A trader who thinks that the EUR/USD price will close at or above 1.2500 at 3:00 p.m. can buy a binary option contract for $40. If the EUR/USD closes at or above 1.2500 as the trader predicted, the payout is $100, meaning the trader makes a $60 profit ($100 payout – $40 cost). If the outcome doesn’t go as anticipated, and the EUR/USD price closes below 1.2500, the loss is the trader’s initial $40 investment.

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Importance

Binary options are a significant concept in business and finance due to their unique structure and implication for traders and investors. Essentially, a binary option is a financial instrument that allows traders to speculate on the price movement of an underlying asset, where the payoff is either a fixed amount or nothing at all. This ‘all or nothing’ nature makes them simple to understand and trade, representing a clear choice between two outcomes. For instance, a trader might purchase a binary option predicting that the price of a certain commodity will increase. If their prediction is correct at the expiry time of the option, they will receive a predetermined payout; else, they lose the investment. Therefore, binary options offer a straightforward and potentially lucrative form of investment, albeit with significant risk. The understanding of this term and its intricacies can vastly enhance a trader’s financial literacy, risk management capabilities, and overall understanding of derivative markets.

Explanation

A binary option is a specialized finance instrument that acts as a bet on the price movements of underlying assets, such as Forex pairs, commodities, or stocks, in a predetermined time frame. The unique purpose of binary options comes from their ‘yes’ or ‘no’ proposition. They serve as a simplified way for investors to predict whether the price of an asset will increase or decrease over a defined period. By doing so, binary options provide an opportunity for short-term investments, bringing potentially high returns, especially attractive to investors willing to take on substantial risks. How they trade is fairly straightforward. When an investor purchases a binary option, they are basically betting on a “binary” outcome– that the price of the chosen asset will either be higher or lower than the entry price (the price when the trade was initiated) by the time the option expires. If the investor correctly predicts the direction of price change, they will receive a predetermined payout, often up to 90% of their initial investment. However, if the prediction is incorrect, they may lose the entire initial investment, hence underlining the high-risk, high-reward nature of binary options.

Examples

Binary Option is a type of financial instrument that allows investors to speculate on the price movement of an underlying asset, such as stocks, commodities, forex, etc. In a binary option, the payoff is either some fixed monetary amount or nothing at all. This makes it a simple, all-or-nothing payoff structure. Here are three real-world examples:1. **Stock Binary Option Trade**: Suppose a trader believes that the stock price of Company XYZ will rise over the next month. The trader can buy a binary call option on XYZ’s stock with a strike price of $50 (the price at which he could buy the underlying asset), expiring in one month. If, at the expiration date, XYZ’s stock is trading above $50, the trader would receive a predetermined fixed payout, say $100. If the stock is trading below $50, he gets nothing.2. **Forex Binary Option Trade**: Assume a trader predicts that the exchange rate for the EUR/USD pair is going to fall. The trader buys a binary put option with a strike rate of 1.20, set to expire in a week. If the EUR/USD rate falls below 1.20 at the option’s expiry, the trader will pocket the predetermined payout. Conversely, if the FX rate is above 1.20 when the option expires, the trader loses the initial investment.3. **Commodity Binary Option Trade**: Let’s say an investor believes that the price of gold will be above $1,800 at the end of day. The investor buys a binary call option on Gold with a strike price of $1,800 that expires at the end of the day. If gold price ends the day at or above $1,800, the investor receives a fixed payout as specified in the contract. If the price is below $1,800, they receive nothing, hence losing the amount they paid for the option.It’s important to note that although binary options can provide an opportunity for profit, they also come with a high level of risk, as incorrect predictions can result in total loss of the investment.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Asset-Underlying: In Binary Option trading, this refers to the specific stock, commodity, index, or forex pair that the option is written on. The condition of the Binary Option depends on the performance of this asset-underlying.
• Expiration Time/Date: The set future point in time at which the Binary Option expires and the trader’s prediction is confirmed to be either correct or incorrect.
• Call Option: One of two types of Binary Options. When a trader predicts that the asset-underlying’s price will rise by the expiration time, they are choosing a Call Option.
• Put Option: The other type of Binary Option. If a trader believes that the asset-underlying’s price will fall by the time of expiration, they opt for a Put Option.
• In-the-money: This is a term used to denote when a prediction about a Binary Option comes true. If a trader’s prediction is correct at the expiration time, their option is described as being “in-the-money”.

Sources for More Information

• Investopedia
• Nadex
• Corporate Finance Institute
• The Motley Fool