Binary options came to the forefront when they were listed in the Chicago Board of Options Exchange (CBOE) in July of 2008. Prior to this time, binary or digital options were traded actively in the over the counter market by institutional investors and major investment banks. So what are Binary Options? Binary options or digital options are “all of nothing “options which give the investor a fixed payout if the criteria of the option are met. This can mean that there is a specific cash payout, or even a specific amount of an underlying asset that is the payout from the option. The CBOE lists binary options, on the S&P 500 index but have not branched out into binary options on the currency, commodity or individual equity markets.Today there are many brokers and market makers who provide a safe and effective binary option platform for the retail investor and the professional traders.
What makes binary options interesting is that the investor receives a fixed payout as a return based on whether the financial market is above or below a specific level at a specific time. As opposed to a standard option, the option buyer can look for a specific payout based on a small move in a financial instrument. When trading standard options, the market has to usually move a great deal for there to be a payout. The structure set up for binary options creates a significant payout, with relatively small moves in the underlying market.
The majority of the time, a binary option is priced at the current market and the investor will be able to receive a return on his/her investment purely based on the short term movement of the financial markets.
This market is relatively easy to understand, and once an investor trades binary instruments, they will quickly understand the benefits relative to other options markets.
An example of a binary Forex option trade is a follows.
An investor believes that the current price of a currency pair, GBP/USD will be above the current price in the next hour. The investor looks on a binary broker’s site at the available binary Options. The investors decides to invest $200 dollars on a binary Forex options that pays a 70% return if the GBP/USD market is above the current market level within 1 hour. This binary Forex option is called a call (above) binary option. In this example, a successful trade would pay the investor $140 dollars plus their initial investment of $200 dollars, for a total of $340. If the market is below the current level within 1 hour, the binary option will return 10% of the initial investment to the trader (in some cases the return on your initial investment is less than 10%). In the case, the binary option trade would return $20 to the investor.
There are also binary options that allow an investor to trade speculate on a specified range over a period of time. These options are called hit or miss options. The hit or miss options require that the trader specify a time frame, and then a price range, and the market maker or broker will then create a price. For example, a trader might purchase a hit option in the time frame right after the US employment number. If the GBP/USD, moves 20 pips higher into the price range that the trader specified in the 5 minutes after the release of the employment report, the trader would receive a payment on his hit option.
Binary options are priced in a manner that is similar to those of standard options. In general, options traders have to analyze the strike price, the underlying price of the financial instrument and the implied volatility of the underlying financial instrument to determine if there is value in the call or put that he is planning on purchasing. Short term binary options eliminate most of the issues related to standard options. The only basis for a successful trade is whether the option is above or below you price after a specific time. The benefit to trading binary options relative to standard options is the investor does not have to contemplate a number of different issues that are faced when trading standard options. There is no exercise into a different product to worry about, and there is no hedging o Greeks, the investor either receives a payout or does not. The best approximation for a standard trader to mimic the payout of a binary option is to use a very tight call or put spread. Unfortunately, even this structure would create an issue unless the time horizon for the payout was very short.
Binary Options Brokers and market makers have made a complex option very easy to use and understand and they allow investors new opportunities to trade the capital markets.