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Definition of binary option : explanation and examples

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Binary options are financial instruments that have grown popular among private investors over the last 5 years. Even though they have faced a lot of criticism (often referred as “scams” by the ones who don’t know and understand this product), binary options are tools that can really generate huge profits once they are fully understood and mastered. Binary options are not a scam, all this bashing is the just the consequence of frustrated people that lost money on binary option trading because they did not understand their mechanism and were unable to manage their risk. Making money in financial markets is far from being easy, this is why nobody should be fooled into thinking trading is simple and without risk. That being said, binary options have the advantage of being extremely simple to understand and being much easier to manage than plain vanilla options because you know the achievable return on your investment form the start.

Many professional traders use binary options on a daily basis to invest or hedge on every asset class (equities, indices, forex and commodities) because they only require a small initial capital that can generate significant gains. Since their creation in 2008, Binary options are regulated and traded on of the biggest exchanges in the world for option trading: the Chicago Board Options Exchange (CBOE). Nevertheless, since most of these binary options are traded Over-the-Counter (OTC) in Europe, you can also trade them at night and during the weekends.

definition-binary-option-explanation-example

Binary Options: Definition

What is a binary option? A binary option is a financial instrument with a payoff that is limited to only 2 alternatives; this is why they are called “binary”: either you chose the correct scenario and you cash in an amount of money that was pre-determined at the time you opened the position, either you chose the wrong scenario and you lose your initial investment. This is what differentiates binary options from “plain vanilla” options. With vanilla option, your final payoff varies with the level of the underlying asset at the maturity of the option. With binary option you always know how much you can make and how much you can lose at the opening of the transaction.

How do binary options work? As explained above, a binary option (binary = only 2 possible outcomes) is an option for which the two possible outcomes are known before you open the position: either you make a profit of Y or you lose X (X being your invested cash amount). You chose a scenario on the relevant asset (do you think the asset price will go up or down?) for a determined time horizon (30 seconds, 1 minute, 10 minutes, 1 hour, 1 day…). At maturity (at the end of the selected time horizon) you look at the realized scenario. If your scenario was that the asset price would go up and it realises than you make a profit of Y, if the asset price went down you loose X.

Example:

In the below example from the 24Option platform, you decide to speculate on the Euro-Dollar exchange rate. The spot rate (current rate) is 1.26868 (1 euro = 1.26868 dollars). This is what you have to do:

  • Select the time horizon (10 minutes in the below example, maturity at “20:45”)
  • Select the direction of your trade (High = above spot rate, Low = below spot rate)
  • Select the invested amount (let’s take 100 € as an example)
  • The platform then automatically propose a return on investment for the trade (85% in the below Example)

binary-option-high-low-example EURUSD

Only two different outcomes are possible at maturity:

Let’s assume you decided to speculate on the upside (you selected the “high” direction). It means you believe the EURUSD Exchange rate will be above 1.26868 in 10 minutes.

  • If at maturity the EURUSD exchange rate is above 1.26868, you earn 85% on your investment or 85 €. You invested 100 €, you cash in 85€ (100 x 85%), you now have a capital of 185€.
  • If at maturity the EURUSD exchange rate is below 1.26868, you lose your invested cash amount, you lose 100 €. Nevertheless, some brokers are proposing “loss return” features, meaning you will not lose your entire invested cash amount. If the loss return is for example 10%, you will get back 10 € (100 x 10%) at maturity from the 100 € invested.

Binary options: Definition and notations

CALL and PUT – These two notations are mainly used for “plain vanilla” options. In the binary option field, a CALL will be the equivalent of a HIGH option and a PUT will be the equivalent of a LOW option.

RETURN – The return is the equivalent of the return on investment (85% in the above example). The return is conditional on the underlying asset and the time horizon of the investment (the more volatile the underlying asset and the longer the maturity, the higher the return)

ONE TOUCH, ZONE – These are other types of binary options, please find a detailed explanation in this related article.

SPEED – Generic notation that qualifies extra short-term binary options (maturity of 60 seconds or less)

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