Binary options trading is quite a complicated type of trading so not many retiree or senior investor may know about it. Basically, it involves the trading of options with only two possible outcomes. Options are contracts that provide buyers (who are typically called the owners or holders) the right to buy or sell the asset or instrument associated with the option for a specific strike price on or before the agreed date. The two possible outcomes of binary options are either a fixed asset value (in cash or asset) or nothing at all. Hence, there are two types of binary options: (1) cash-or-nothing and (2) asset-or-nothing.
Important Terms to Remember
Before proceeding to the discussion on how binary options trading works, it’s important to remember the following terms:
- Broker – This is a person or company that serves as an agent or point of contact for traders and those who want to buy. Examples of which are OptionsXO, 24Option, and AnyOption. You can visit OptionsXO’s Facebook page and get involved with the community.
- Holder – This refers to the buyer or owner of the binary options.
- Underlying Asset – This is the asset with which an option is associated. It could mean shares of stocks (or stocks), commodities such as precious metals and crude oil, indices, and currencies.
- Strike Price – Also known as target or purchase price, the strike price means the price of the underlying asset at the time when the purchase of the option was made. This is the price referred to when the phrase “struck at” is used.
- Expiry Date – Also known as the maturity date, this means the date at which the option matures. An option that expires can no longer be traded. Generally, binary options have significantly shorter expiry dates. Binary options can expire in as short as 1 minute or relatively long at 1 or a few weeks.
- Call – This is like a descriptive term for a binary option in which the value of the underlying asset is predicted to increase by the time of expiration.
- Put – The opposite of “call,” this is used to mean a binary option predicted to have a reduction in strike price.
It’s important to remember that the purchase of binary options that does not mean the transfer of the ownership of the underlying asset to the option purchaser or holder. No transfer of asset ownership takes place and the claiming of the payoff amount may only be done on the maturity or expiry date of the option.
How It Works – Illustration
Consider the following sample case (take note of the boldfaced terms):
A cash-or-nothing call option for the stock of Sample Corporation is struck at $500 and with a binary payoff of $6,000, and with the expiry date set at June 6, 2016.
Given this sample case, the following can be inferred.
- The binary option here is a cash-or-nothing option that yields a payoff if the underlying asset (the stocks of Sample Corporation) increases (call) in price by the time of the expiration or maturity.
- If the price of Sample Corporation’s stock hits $600 on June 6, 2016, the holder of the option receives $6,000.
- If the price of Sample Corporation’s stock hits $90 on June 6, 2016, the holder does not receive anything.
- If the stock price stays at $500, the money used to buy the option may be returned to the holder.
Nothing May Mean Something
Although the phrase “all or nothing” is often used in binary options trading, there are instances when something actually comes out of “nothing.” It depends on the trading platform. There are trading platforms that provide a certain payout to option holders upon expiry. This is the fourth inference mentioned in the illustration above.
Binary Options vs Digital Options
Digital options and digital options are one and the same. The difference is that digital options is the term more commonly used for binary options traded in the foreign exchange market. As such, the underlying asset is generally currency.
Essentially, binary options is about betting or wagering on the price or value of the underlying asset. It is completely separate from stock trading and other forms of investments. It is about making (or losing) money out of a separate event, just like betting on the highlight numbers of a jai-alai or a horse race.