Posted on 06 August 2012.
Binary Options are becoming increasingly discussed in financial circles, which raises the question in many stock market traders and investors minds: What Are Binary Options? Binary Options are all or nothing options that offer a way to bet on the price of various financial instruments (such as specific stocks, stock market index futures, currencies, or commodities) during specific time periods, from hours to days to weeks. A binary option will pay a set but limited payout, if option’s strike price is exceeded, but will expire worthless, if the option’s strike price is not exceeded. This is what makes binary options “all or nothing options”, they either pay their full amount or they pay nothing.
While binary options have existed on the Over the Counter (OTC) markets on Wall Street for many years, they have only garnered the attention of individual investors in recent years, as binary options trading platforms (websites) have sprung up to facilitate the easy trading of binary options. These binary options trading websites allow traders and investors to buy binary options electronically, and receive pay outs for any gains immediately upon option expiration.
Unlike traditional options that can payout at various amounts, based on the value of the underlying financial product at the time of option expiration, there are only two (binary) outcomes possible to a binary options trade: a fixed payout (if the strike price is reached upon expiration) or no payout (if the strike price is not reach upon expiration).
Perhaps the best way to answer the question “What Are Binary Options?” is to provide an example of a binary option trade.
If a hypothetical purchase is made of ten binary cash call options on Apple Inc’s stock (AAPL) that expire at the end of the day with a strike price of at $600, with a payout of $100 on each option, if the strike price is exceeded, the ten binary cash call options may cost $30 each, or a total of $300 for the ten options. If AAPL closes in regular trading below the $600 per share strike price, the ten binary cash call options would expire worthless, and the purchaser of the options would loss the $300 spent on buying the options. If AAPL closes in regular trading above the $600 per share strike price, the ten binary cash call options would pay $100 each, or a total of $1,000, which would result in a net gain, minus commissions, of $700 for the purchaser of the options ($1,000 payout minus the $300 spent purchasing the binary options). This binary option trade could also be made on the short side by purchasing binary cash put options on AAPL’s stock, if one believes AAPL’s price will fall in the short term.
Binary options are essentially short term bets on the closing price of various financial instruments that provide specific payouts, if the strike price is exceed at option expiration, and cap the risk of loss to the total cost of purchasing the binary options.
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