Binary Options Trading
Binary Option Example
Definition of Binary Options:
Binary Options are like regular options in that they allow you to make a bet as to the future price of a stock.
However, binary options are different in that if the "strike price" is met by the expiration date, the binary option has a fixed payoff of $100 per contract. It doesn't matter if the stock price is a penny over the "strike price" or if it is $100 over the strike price, they payoff from the binary option is the same--$100.
They are called binary options for this very reason.
Binary means "2" and binary options have only 2 possible payoffs--all or nothing ($100 or $0). In 2008 the AMEX (American Stock Exchange) and the CBOE started trading binary options on a few stocks and a few indices; trading binary options is NOT available on very many stocks or indices just yet.
The United States has been slow to accept binary option trading, but binary option trading has been quite popular in Europe for a few years, especially as they relate to FOREX. The best way to understand these relatively new type of securities is to look at the example below.
Example of a "Binary Option"
Suppose GOOG is at $590 a share and you believe GOOG will close at or above $600 this week.
You could buy 5 GOOG Binary Options for a price of, say, $0.30. The multiplier on the binary options is also 100 so five of these options would cost 5 contracts x $0.30 * 100 multiplier=$150.
If GOOG closes at $600 or higher by the expiration date then the binary option is worth $100 so five of these GOOG call options would be worth $500, for a profit of $350.
It doesn't matter if GOOG closed at $600 or $650, the binary option is still worth $100. If GOOG closes at $599.99 or lower, then the option expires worthless.
Currently, all binary options are traded as European style, which means they can only be exercised or settled at expiration.
In the U.S., the CBOE offers binary contracts on 2 indices, the SandP 500 Index (SPX) and the CBOE Volatility Index (VIX). The tickers for these binary contracts are BSZ and BVZ.
If you want to trade them, there are not many popular brokers that have added them to their platform.
The ETRADEs, TD Ameritrades, Schwabs, and Scottrades have not added them to their platform yet. If you follow some of the ads on the web, the brokers that trade them are not commonly known so there is great risk.
Another Example of Binary Options:
Unlike traditional calls and puts, binary options do not have set prices.
The binary options trader decides the amount of money he wants to bet and invests that amount when he buys the binary option.
American Binary Option Pricing: 3 Period Binomial Tree Model
If the price is $0.25 then he stands to make $0.75 if the underlying moves as much as the investor hopes. The time of expiration for binary options is set at different time intervals throughout the day, such as expirations of 1 hour, 1 day, 1 month, etc.
The short duration of these contracts makes them more attractive to speculators and risk takers.
Next: What are American style options?