Binary options traded outside the U.S. are typically structured differently than binaries available on U.S. exchanges. When considering speculating or hedging, binary options are an alternative, but only if the trader fully understands the two potential outcomes of these “exotic options.”
U.S. Binary Options Explained
Binary options provide a way to trade markets with capped risk and capped profit potential, based on a ‘yes’ or ‘no’ proposition.
For example: Will the price of gold be above $1,250 at 1:30 p.m. today?
If you believe it will be, you buy the binary option. If think gold will be below $1,250 at 1:30 p.m., then you sell this binary option.
The price of a binary option is always between $0 and $100, and just like other financial markets, there is a bid and ask price.
The above binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then you will pay $44.50, if you decide to sell right then you’ll sell at $42.50.
Let’s assume you decide to buy at $44.50. If at 1:30 p.m. the the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100 – $44.50 = $55.50 (less fees). This is called being “in the money.”
But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This called “out of the money.”
The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss (compared to letting it expire out of the money).
A Zero-sum Game
Eventually every option settles at $100 or $0; $100 if the binary option proposition is true, and $0 if it turns out to be false. Thus each binary option has a total value potential of $100, and it is a zero-sum game – what you make someone else loses, and what you lose someone else makes.
Each trader must put up the capital for their side of the trade. In the examples above, you purchased an option at $44.50, and someone sold you that option. Your maximum risk is $44.50 if the option settles at $0, therefore the trade costs you $44.50. The person who sold to you has a maximum risk of $55.50 if the option settles at $100 ($100 – $44.50 = $55.50).
A trader may purchase multiple contracts, if desired.
Another example: NASDAQ US Tech 100 index > $3,784 (11 a.m.).
The current bid and offer is $74.00 and $80.00, respectively. If you think the index will be above $3,784 at 11 a.m., you buy the binary option at $80 (or place a bid at a lower price and hope someone sells to you at that price). If you the think the index will be below $3,784 at that time, you sell at $74.00 (or place an offer above that price and hope someone buys it from you).
You decide to sell at $74.00, believing the index is going to fall below $3,784 (called the “strike price”) by 11 a.m. And if you really like the trade, you can sell (or buy) multiple contracts.
Figure 1 shows a trade to sell five contracts (“size”) at $74.00. The Nadex platform automatically calculates your maximum loss and gain when you create an order, called a “ticket.”