Introduction to Binary Options

A binary option is an option that pays either a fixed amount or nothing, depending on whether a certain condition is fulfilled when the option expires.

Binary options are also referred to as all-or-nothing options, since it is a type of option where the payoff is all or nothing. The return is therefore fixed and it comes as no surprise that such options are also known as: FRO's-Fixed Return Options. Digital options is also another commonly used term. More simply a trader just needs to make a decision about the direction of a rate change: Whether the underlying asset's price is going up or going down without taking other factors into consideration.

Binaries are considered to be one of the simplest trading products out there, where the trader knows their exact exposure and potential gains at the time of placing a trade.

Binary Options trading is considered as one of the fastest growing simplified trading products.

Binaries are considered as a mass market financial instrument as it empowers traders with a very flexible trading approach without the complexities involved in trading traditional vanilla options. Whether you are looking for a short term speculation or hedging your portfolio, binaries can help you get a high payout within short trading periods and as such are gaining global popularity among traders.

Binary contracts are available on a variety of underlying assets: Stocks, Commodities, Currencies and Indices.

If a trader has made a call or put and at contract expiration has been successful with regards to the anticipated direction of the underlying asset price, the contract will expire 'in the money'. On the other hand, if the trader has been unsuccessful in anticipating the direction of the asset, the contract will expire 'out of the money'.

When the expiry level is equal to the strike price the contract will expire 'at the money'. Normally, there will be a fixed cash settlement to be returned which is often the initial investment, however this depends on what was predetermined and agreed in the contract.

A Binary Option reflects specific speculation in financial markets that may happen during a specific time period.

For example:  
 Google price is now $801.25 and you want to speculate on the price movement of the share within a time frame of 1 hour.

If you think that Google will rise above this price level, than you should buy a binary call option - if the Google price closes above the current price level during expiry than the option will expire 'in the money', paying you the fixed odds return promised during the trade. If not, the option will expire 'out of the money'. If you think that Google will fall below this price level, than you should buy a binary put option - if Google's price closes below the current price level during expiry than the option will expire 'in the money', paying you the fixed odds return promised during the trade. If not, the option will expire 'out of the money'.

The Difference between Binary and Vanilla Options

Binary options, also known as digital options, are similar to ordinary options in the sense that the payoff is based on the price of the underlying asset when the contract expires, however, with a binary option, the trader only needs to take a view on the anticipated direction of the underlying asset price and doesn't need to take magnitude into consideration.
The main difference between a regular vanilla option and a digital option is the extent to how much a contract can potentially lose or gain. Binary options are often referred to as FRO's fixed rate options, since the contract will have a predetermined percentage of fixed rate of return. Unlike traditional vanilla options which are much riskier, since the potential gains are infinite, of course risk can be managed by strategical stop loss orders.

Binary Options Vs Traditional Options Comparison

Advantages of Binary Options

Simplicity - Will the asset close above or below?

Binary options are simple to understand and straightforward to trade as the trader only needs to consider the direction of the asset price.
Limited risk and predetermined payout.
The payoff of a binary option contract is fixed and pre-determined so, therefore, the potential risk and reward is known from the outset. With traditional options, there are no outlined parameters so the possible loss or gain is not known.
The binary option will settle the contract irrespective of how much the asset price is 'in the money' at expiration. Therefore even if the contract is only successful by one tick the contract still pays out at the fixed level.
Simplified hedging of your portfolio.
Binary options are often used as an effective tool to hedge existing positions. As a product binary options are compatible to most commonly used trading methods and strategies. Also with binary options it is possible to offer a a greater selection of short-term contracts across all markets, which enables the intra-day trader to trade more frequently.
As opposed to vanilla options, while trading binary options the options can close 'in the money' collecting the full payoff even with a minimal price change of a single pip.
Binary options are issued 24/7, allowing traders to trade on multiple time frames. As binaries are offerred on a variety of global underlying assets from different exchanges, traders are now able to trade binary options 24/7 from the same binary options platform.

Binary Option Trading Strategies

A very common strategy is to make a put or call option once there has been a big move in the market, especially if it is an unexpected move.

Often binary option traders will open positions related to events that historically have a big influence on market prices. For example, quarterly profit or loss announcements from firms are eagerly watched by potential traders, since positive or negative results often reflect the movement of the share prices. As well as formal preplanned announcements, traders will always be watching the news, as many different events can influence the markets i.e. Natural disasters to political changes. Eventually the best strategies come with experience and knowing what to watch.

Binary Options in Global Financial Markets

Binary options falls under the umbrella of exotic options but within financial markets they are often referred to as digital options. Whilst digital options are very simple to understand and easily traded, the calculation behind the pricing is sophisticated. It is for this reason digital options are known as exotic options.

Digital options are usually traded OTC (over the counter) across all assets in financial markets but are more commonly used within the Forex and Interest markets. More recently numerous stock exchanges have produced listed digital options on selected stocks, commonly known as FRO's (fixed return options). Today, the CBOE offers fixed return options on S&P500 and VIX. Additionally, 20 stocks were listed on AMEX in 2008.