What is a binary option?
– A binary option is a financial derivative that pays a fixed amount if a stated condition is true at expiration and pays nothing if it is false. The condition is a simple yes/no proposition about an underlying price or event—hence “binary.”
How a binary option works (step‑by‑step)
1. Choose an underlying (stock, index, commodity, currency, or a specific event).
2. Pick a strike or reference level and an expiry date/time. The contract asks a yes/no question (e.g., “Will stock X be above $25 at 10:45 a.m. on April 22?”).
3. Buy the “yes” (call) or “no” (put) binary. The purchase price equals your maximum possible loss on that trade.
4. At expiration the option automatically settles: if the condition is true (“in the money”) you receive the payout specified by the contract; if false (“out of the money”) you lose the amount you paid. There is no partial exercise—payouts are all or nothing.
Key definitions
– Derivative: a contract whose value is derived from an underlying asset or event.
– Expiry: the date and time when the binary option settles.
– In the money (ITM): the condition is true at expiry and the contract pays out.
– Out of the money (OTM): the condition is false at expiry and the contract pays nothing.
– Vanilla option: a standard call or put option that gives the holder the right (but not the obligation) to buy/sell an underlying asset, with payoffs that vary with how far the underlying moves.
Binary options vs. vanilla options (important differences)
– Ownership: Vanilla options can lead to ownership or the exercise of a position in the underlying asset; binary options never result in ownership—they are pure bets on an outcome.
– Payoff profile: Binary options have a fixed maximum payout and a clearly defined maximum loss (the amount paid to buy the option). Vanilla option profits vary with the underlying’s price movement beyond the strike.
– Regulation: Standard vanilla options typically trade on regulated exchanges under established market rules. Binary options sometimes trade on regulated exchanges (e.g., Nadex in the U.S.), but much global activity occurs on unregulated offshore platforms—raising fraud risk.
– Exercise: Binary options often auto‑exercise at expiry with an all-or-nothing result. Vanilla options can sometimes be exercised before expiry (American style) or only at expiry (European style).
A short numeric example (worked)
Example A — Simple payout example:
– Contract: “Will ABC shares be above $25 at 10:45 a.m. April 22?”
– Stake (what you pay to buy the binary): $100.
– Payout if ITM: 70% (per contract terms).
If ABC is above $25 at expiry: you receive a payout of $70 in addition to keeping your $100 stake, so your account increases by $70 (net profit = $70).
If ABC is below $25 at expiry: you lose the $100 you paid.
Example B — Entry price example (standardized $100 expiry):
– Underlying: Colgate-Palmolive trading at $64.75.
– Binary strike: $65, expires
at 1:00 p.m. today.
– Entry (price you pay to buy the binary): $40.
– Standardized payout if ITM at expiry: $100.
– Outcome 1 — Colgate closes at or above $65: you receive $100. Net profit = $100 – $40 = $60 (150% return on the $40 stake).
– Outcome 2 — Colgate closes below $65: you receive $0. Net loss = $40 (you lose your stake).
Notes on Example B: The market price of $40 implies the market places a 40% probability on Colgate finishing at or above $65. If you believe the true probability is higher than 40%, buying this contract has positive expected value; if you think it’s lower, selling the contract would be the edge.
Pricing, implied probability, and expected value
– Implied probability (for a standardized $100 payout) = market price / $100. Example: price $40 → implied probability 0.40 (40%).
– Expected value (EV) to a buyer = (true probability of ITM × $100) − price paid. Example: if your estimated true probability = 45% and you buy at $40: EV = 0.45×100 − 40 = $5 expected profit per contract.
– Expected value to a seller (writer) = price received − (true probability × $100). Using the same numbers, if you sell at $40 and your true probability is 45%: EV = 40 − 0.45×100 = −$5 (an expected loss).
Worked numeric checklist for assessing a trade
1. Record market price and payout (e.g., price = $40; payout = $100).
2. Compute implied market probability = price / payout (40/100 = 40%).
3. Estimate your own probability (research, models, edge). Example: 45%.
4. Compute buyer EV = (your prob × payout) − price = 45 − 40 = +$5.
5. Compute ROI if ITM = (payout − price) / price = (100 − 40)/40 = 150%.
6. Size position so EV × number of contracts fits your risk tolerance.
Common mechanics and variations
– Entry-price binaries: quoted between $0 and $100 representing immediate buy/sell price. Settlement pays $100 if ITM, $0 if OTM.
– Fixed-return binaries: some contracts quote payout as a percentage of stake (e.g., 70% return on win). Convert to the $100 standard before computing implied probabilities.
– Early-exercise / American style: rare for retail binaries; most are European style (settle only at expiry). Confirm with contract terms.
– Settlement price: exchanges or brokers use a specific reference (last trade, official close, or an index) — read the settlement rule to avoid surprises.
Risk characteristics and practical risk management
– All-or-nothing payoff creates large tail risk: single contracts can lose 100% of the stake.
– Edge must be clear: because fees and spreads are typically embedded, you need a true-probability advantage to earn positive EV.
– Position sizing: use rules (e.g., risk no more than a small fixed percent of capital per trade). Do not treat binaries as a way to “bet big” expecting quick outsized wins.
– Account for transaction costs: bid/ask spreads and platform fees reduce your edge. Always use the round-trip cost when computing EV.