Ever since their release, binary options have been extremely popular, especially among retail traders. The reason for this is that they are perceived to be much less complex than traditional vanilla options.
In the US binary options have been approved for listing on a number of indexes, stocks and ETFs.
A binary option, also known as a digital option, works similar to a call or put option, except that if the option expires In The Money the buyer is entitled to receive a fixed amount from the seller. Whether the option therefore expires 1% or 90% In The Money is irrelevant – the payout remains the same.
The seller thus takes on a fixed, known risk and the buyer knows exactly what the maximum profit/loss of the trade is when entering the trade.
In a sense it is very similar to taking a bet that the price of the option would be above or below the strike price at expiration.
Binary call options
A Binary Call option works very similar to a vanilla call option. If the price of the underlying asset exceeds the strike price by expiration, the buyer will, however, receive a fixed payout, e.g. 70% of the price of the option. The holder of a vanilla option could theoretically earn a much bigger profit upon expiration, but if the underlying price only exceeds the strike price by a very small amount at expiration this individual will of course receive a much smaller payout than someone holding a binary call option.
Binary put option
The Binary put option pays out a fixed amount if the price of the underlying asset ends below the strike price at expiration, regardless of how far below. Once again these options will therefore be more profitable than vanilla put options if the price ends slightly below the strike price, but less profitable than vanilla put options if the price drops substantially.
Other types of binary options
Various other types of Binary Options have become available during recent years, including one touch binary options and range binary options.
One touch binary options. With this type of binary option, the buyer receives a fixed payout if the underlying prices touche the strike price of the option at any time before expiration. If it never touches the strike price, 100% of the premium is usually lost.
Range binary options. With range binary options the buyer in fact takes a bet that the underlying price will remain within a certain range between now and the expiration date. If it ever touches or exceeds the strike price, the premium is lost; if it remains within the boundaries of the range it entitles the buyer to a fixed payout upon expiration.
Generally speaking there are two schools of thought when it comes to binary options. The first group considers binaries to be an improvement on the standard, rather involved vanilla options; the second group considers binary options to be a form of gambling rather than a form of investment or trading.