Let’s first get back to the definition of an option. A common option (also called a plain vanilla option) is a derivative contract between a buyer and a seller. The buyer of a call option (respectively put option) is entitled to buy (respectively sell) an asset at a pre-determined price at a certain time in the future. The seller of the option is forced to Sell (respectively Buy) the related asset at the pre-determined price at maturity of the contract if it is required by the buyer to do so (the buyer use his right to exercise the option). The asset, asset price and maturity are agreed between the buyer and the seller at the inception of the contract. An option that entitled the buyer to buy the underlying asset at maturity is called a CALL while an option that entitled the buyer to sell the underlying asset at maturity is called a PUT. An option belongs to the derivatives class of financial instruments because the option value is based on the value and evolution of the underlying asset price (it is derived from it).
Binary options: simpler to understand and to value
Binary options are a lot simpler than regular options to trade. This is the biggest advantage of binary options, but first, lets get back to the definition of a binary option. You only need to choose 3 criteria: the underlying, the direction of your trade (Bullish or Bearish) and the maturity. With common options, you have a lot more criteria to select (CALL or PUT, Buy or Sell, select the strike (the strike is the pre-determined price at which the buyer will be able to acquire the underlying at maturity), select the maturity, select the underlying, select the option type (American or European: see below for details)…).
The valuation of binary option is also a lot more straight forward. You always know the achievable return of the binary option when you open the position and there is only 2 possible outcomes: you earn the return or you lose the invested cash amount (or you get back the « loss return »). Regular option valuation is extremely complex and is impacted by multiple factors : the volatility, the strike price, the relative level of the underlying, the time value…
Differences between binary options and traditional options
Comparative analysis of binary options and regular options
|Characteritics||Regular options (Vanilla)||Binary options|
|Maturity||Monthly with up to 2 years||60 seconds, 15 minutes, 1 hour, 1 day|
|Payoff||Conditional to underlying price at maturity||Previouly known (set at the opening of the trade)|
|Exercise time||Anytime before expiry for American Style Option – At maturity for Euopean Style option||No Exercise, payoff at maturity|
|Exercise right||Possibility to exercise the option by the buyer and Buy (respectively Sell) the underlying asset||Only cash settled|
Maturity: Binary option maturities are a lot shorter than vanilla option maturities (it is a different type of investment, short-term vs. medium-term). Binary option maturities range from 60 seconds (« Speed Binary Trading ») to a few days while common option maturities range from 1 month to several years. The most popular maturity for binary options is 15 minutes; this is why you will see a lot of binary option brokers propose you this maturity by default.
Payoff: For regular option, final profit or final payoff depends on the level of the underlying at maturity. If you buy a call option on oil for example: the higher the price of oil at maturity of your option, the higher the payoff of the option. Binary options payoff is not conditional to the level of the underlying, the return is known at the moment you open the position. If you buy a High binary option on gold, whatever the level of gold at maturity, if it is above the initial price you will earn the agreed return on your invested amount. This difference makes binary option a lot more transparent and lot more easy to use for traders. Risk management is made easier because you already know how much you can make and how much you can lose.
Exercise: Binary options are only executed at maturity. When you buy a binary option, you need to wait for the maturity and look at the level of the underlying to know if you generate a profit or a loss. Regular options have a secondary market; it means that you can sell an option at any point in time or that you can buy back an option that was initially sold in order to neutralize your market exposure. Moreover, there exist two types of common options: American options can be executed by the buyer at any point in time between the purchase and the maturity of the contract while European options can only be executed at the exact time of the maturity by the buyer. Warning, for vanilla options, when the buyer executes its option, he buys the underlying at the pre-determined price that was agreed with the seller at the inception of the contract.
In practice, all the recommend brokers on the website propose early closure and roll-over functionalities that enable you to either sell back your option before expiry or extend the maturity of your option. Don’t hesitate to have a look at our reviews of OptionTime, 24Option, AnyOption or TopOption for further information on these functionalities and on the offer of each online broker.