Binary option Explained

Before anyone can consider trading Binary Options, they have to have an understanding of the fundamentals behind the options including how they work and how they differ from traditional options. In other words, a binary option explained in simple terms.

Binary Options have often been touted as “easy” ways to make money. This may indeed seem slightly disingenuous. This is because only those who have an understanding of options can make money.

Binary Options are also often misunderstood as an instrument. They are thought of as taken mere “bets” on the underlying instrument. Although practically correct, the technicality behind it is not quite as clear cut.

In this post we will go through some of the basics of Binary Options so that when you are ready to trade the instruments you have a better grasp of various factors will impact on the binary option.

What is an Option?

Before we can look at the fundamentals behind Binary Options, we have to cover the concept of financial options and what they are exactly.

A financial Option is a derivative instrument. In other words, it is a financial instrument that gets its value from the price of some other asset. Hence the value of an option is “derived” from an asset such as a share, forex or commodity.

In essence, an option allows the holder the right but not the obligation to buy / sell the underlying asset from the option seller at a predetermined time (T) and price (x). The expiry time (t) and the price (x) are both very important inputs in the Binary Option price.

There are two types of financial options. They are the CALL and the PUT option. A CALL option gives the holder the right to buy the underlying asset at the strike price on the expiry. The PUT option gives the holder the right to sell the underlying asset.

The goal of the option trader is to exercise the option and buy/sell the asset if the price is above the strike/below the strike in the case of the CALL/PUT option. This will yield the trader the profit which is the difference between the prevailing price and the strike (less the option price).

However, most option traders don’t tend to exercise the option and prefer to receive the payout from the option seller. The theory behind trading traditional vanilla options can be quite complex and is hence is mostly traded on wall street with advanced “volatility” traders.

Things are, however, slightly different when it comes to Binary Options. Although they share some of the same option greeks technicalities, they can be traded in an easier fashion.

Explaining Binary Options

In mathematics, binary is the reference to one of two numbers, either 1 or 0. In a similar fashion, in statistical theory, a binary outcome is one in which there are only two outcomes.

This is why binary options are termed as such. Unlike traditional options, there are only two payouts with a binary option. They are either 1 (or 100) or zero. Hence the trader will either get the payout value or will lose their initial investment.
Binary Option Payoff

This is why Binary Options are often thought about as “bets”. Hence, if the option expires in the money (ITM) the trader knows the exact amount that they will be getting. The same is said when the option expires out of the money.

This difference between traditional options and Binary Options is better explained with a graph. As one can see in the graph to the right the payoff profile of a Binary Option as compared to a traditional option.

These options are still considered exotic instruments at global investment banks as Over the Counter (OTC) instruments. They are also generally quite hard to price given their binary payoff.

However, they have taken on a life of their own in the retail binary options market. The original binary option instrument is seen as a simple Up or Down investment. In other words the trader will either get paid if the option is above or below the entry point.

In order to explain binary options appropriately, we need to take a look at a few examples of binary option trades.

Example Binary Option Trades

When it comes to trading High/Low (Up/Down) binary options on an investment platform, the trading parameters are usually quite simplified and easy to select.

You will have to select the asset that you would like to trade as well as the expiry time, whether it will go up or down and payout rate. The payout rate is the amount in % that you will be paid out if the option expires in the money.

Taking a look at the below platform, we have the IQOption trading interface. As you can see, the trader can select the parameters that he favours and this will then impact the expiry price (x). In this case, the trader suspects that the price of gold will increase in the next 7 minutes.

IQOption High/Low Trade

In the above example, if the trader had decided to enter the Binary CALL option at the entry price then the expiry level is given by the current level. The trader also has a 75% payout ratio so if this option ends in the money then the trader will earn 75% of his investment ($75 in this case).

If, however, the option was to expire out of the money then the trader would get nothing and lose the initial investment. In this case the trade will be determined on the expiry which is 7 minutes from now.

Let us take a look at another example, in this case the trader suspects that EURUSD will decrease in the next 30 minutes. This would mean entering a Binary PUT option on EURUSD expiring in 32 minutes. In the case of this PUT option the payout ratio is 81% so the trader will get $81.

ETXCapital High/Low Trade

The higher payout ratio will mean that the entry point (expiry price) will be priced slightly more out of range. Hence, if EURUSD is below the expiry price at the end of the 30 minutes then the trader will get 81% of their investment.

Other Binary Options

Although a simple High / Low Binary Option was appealing to many traders, there were quite a few who wanted to implement a range of strategies on Binary Options. As a result, Binary Option brokers decided to offer a number of more interesting Binary Option types.

Touch / No Touch Options

These are a particular type of Binary Option where the trader gets a large payout if the price of an asset touches / does not touch a particular level. They are a particular variant of traditional vanilla knock in options.

These are an interesting type of Binary Option for those who want a really large payout ratio (usually over 100%). They are also generally quite risky as the touch / no touch barrier is usually set quite far away from traditional High Low expiry levels.

In the below image, we have an example of a one touch trade on ETX Capital’s platform. In this one touch AUD/USD option, the trader is taking the view that the price will touch 0.75997 level before expiry of the option (44 minutes time)

ETXCapital Touch Option

If the option does indeed touch this upper level then the trader will receive 100% return on the investment and the payout will be $200.

With some brokers, the client has the option to set the level of the touch / no touch. The further away from the strike that the client moves, the larger the payout amount.

One Touch options are a good investment if the trader is trying to take advantage of high volatility or a lack thereof in the markets. It is also not an option type that a new trader should not really consider investing in.

Barrier Options

A barrier option is just a combination of two touch / no touch options. The trader takes the view that the option will remain either within or out of an upper and lower barrier. This is also sometimes called a “tunnel” option.

The payoff of the barrier option can either be bigger or smaller than the Touch / No Touch option. For example, if you enter a touch tunnel trade the payoff can be slightly less as there is more chance that it could either breach above or below.

On the other hand if you enter a no-touch tunnel trade then the payoff can be much larger. This is because the chances of the option not breaching the upper or lower limit is much less.

Taking a look at the 24Option platform screenshot below, we can see the setup for a EURUSD tunnel trade. The upper boundary of the tunnel is 1.3710 and the lower is 1.3706. If the trader had a view that EURUSD would end up between the two boundaries for the next 5 minutes then they would enter into a “in” boundary trade.

24Option Tunnel Trade

If the trade remained between the two levels then this would be a trade that ended in the money with $170 being the payoff. The opposite can be said for a trade where the option would go out of the tunnel. The trader would then enter into an “out” tunnel trade.