Binary options contracts are known by a number of different names such as all-or-nothing, digital, or even fixed return options. They are defined by one specific feature; they pay out a fixed return to the holder if they are making a profit by the time of expiration, regardless of how much profit they have gained. They are called binary options simply because there are two possible outcomes – the holder either gets the fixed pay out or loses their initial investment.
They have been around for quite some time, and they were originally considered an exotic contract type. Because of this, they were only available over the counter. They are still available over the counter, but following a rule change by the Options Clearing Corporation which led to standardized features of a range of binary options, the Securities and Exchange Commission approved their listing on the exchanges. Since 2008 some exchanges have listed binary options on a number of stock and indices and a variety of exchange traded funds.
There are a few different types of binary options, as they can be classified in a number of different ways. On this page we provide further information on these types and how they can be used as part of your trading strategy. We also provide details of how you can buy and sell them.
- Binary Calls & Binary Puts
- Exercise Style
- Strategy for Trading Binary Options
- Buying and Selling Binary Options
Binary Calls & Binary Puts
The two main types of options contracts in general are calls, which you would buy if you expected the underlying security to rise in price, and puts which you would buy if you expected the underlying security to fall in price. These same categories can be used to classify binary options and the same principles apply; you would buy binary calls on an underlying security you thought would increase in price and binary puts on an underlying security you thought would fall in price.
Therefore, if you owned binary calls and the price of the relevant underlying security was above the specified strike price at the time of expiration – i.e. the contract was in the money – then you would receive a fixed pay-out. The pay-out would be based on either a fixed absolute amount per contract owned (for example $1), or a fixed percentage of the original investment (for example 75%).
If the price of the underlying security was below the specified strike price at the time of expiration, i.e. the contract was out of the money, then you would lose the money you had invested in those contracts. Some binary options can actually allow for a certain percentage of the price of the contracts to be returned to the holder when they complete the contract. The contracts are usually written with a strike price equal to the price of the underlying security, which is known as being at the money.
If you were to buy binary puts, then the situation is reversed. The contract would be in the money at the time of expiration if the price of the underlying security was below the strike price then you would receive a pay-out in those circumstances. You would lose your investment, or gain any percentage returned to you under the terms of the contract. Only if the contract was out of the money at the time of expiration this would occur. A binary put would be out of the money if the price of the underlying security was above the specified strike price.
Binary options will be one of two styles based on how they can be exercised; there are American style contracts and European style binary contacts. American style contracts allow the holder to exercise at any time during the term of the contract, while European style contracts are not as flexible, and holders of those contracts can only exercise at the point of expiration. Given the nature of binary options they are usually European style, and are automatically exercised at expiration if they are in the money.
Binary options can be further classified based on how they are settled. Any contract is settled in one of two ways: a physical settlement or a cash settlement. The majority of binary options are cash settled, meaning that any profit is paid for in cash. Contracts that are settled in this way are known as cash-or-nothing options. There are also asset-or-nothing contracts, which can be settled with the underlying asset, but these are much less common.
Strategy for Trading Binary Options
There are a number of trading strategies that use binary options. In particular, they can be useful for hedging existing positions that are profitable. For example, if you owned stocks that you already made some money on but were concerned that they might drop off in price a little, then you could buy binary puts based on those stocks. If the price of your stocks did indeed fall in price by a small amount, you may offset some or all of that drop by the return from your puts.
Binary puts would not offer you full protection against a significant fall in price, but this does represent a relatively cost effective way to protect against small to moderate falls. If you were concerned about a significant fall in the price of stocks you owned then you may be better off selling those stocks or using a standard put.
Buying & Selling Binary Options
Some binary options are available on the easily accessible exchange markets, while others are only available over the counter. If you are buying exchange traded contracts then you can use pretty much any broker. For the easiest and cheapest way to trade these binary options you should consider brokers that typically have low commissions and fees and still offer an efficient service. If you are buying over the counter, then you might be better off choosing a broker suitable for over the counter transactions.