There are 2 scenarios in which binary options are normally chosen. The first is in a very volatile and illiquid market, such as exotic currencies. If a company is trading an asset in the exchange, it may decide to hedge itself with a binary option against irregular movements in the asset’s price. The second scenario is in a calm market where large profits from a traditional trade are rare due to small price changes. Since binary options offer a fixed return regardless of the change in the asset’s price, they will give a much better return.
To understand this fully, it’s worthwhile to learn exactly what binary options are and how they work.
An option is a contract which gives a buyer the right (but not the obligation) to buy or sell an underlying asset at a fixed price, within a specified time frame to a seller (or writer). Put more simply, it’s an agreement to exchange something in the future. Depending on which direction the asset moves in, will affect if the buyer or seller benefits from the exchange since the price has been set in advance. It’s important to note that in binary option trading, it is a contract which is being purchased and not the asset itself.
Firstly, he must choose his underlying asset, be it a currency pair, index, stock or commodity. Next he must watch the price movement of the asset and purchase the contract at a set price - this is known as the strike price. Thirdly, the last date when the option can be exercised must be selected. This is called the expiry time and could be the end of the nearest hour, day, week or month. It is the price of the underlying asset at the expiry time that determines the outcome of the option.
If he estimates that at the expiry time, the price of the underlying asset will be above the strike price, then he purchases a Call option. If he estimates that at the expiry time, the price of the underlying asset will be below the strike price, then he purchases a Put option.
So, if at the option’s expiry time, the price of the underlying asset is above the strike price (in a Call option) or below it (in a Put option) then the option is said to be in-the-money. If at the expiry time, the price of the underlying asset is below the strike price (in a Call option) or above it (in a Put option) then the option is said to be out-of-the-money.
Depending on where the option was purchased – through a broker or an online trading platform – will depend on the return rate that a buyer will receive if his option expires in-the-money. The standard rule for options expiring out-of-the-money is that the total investment amount is lost. However, there are platforms that give a refund of a percentage of the investment, to those options expiring out-of-the-money. One such site is www.anyoption.com which offers a 15% refund when buying options on over 50 assets.
For this reason, the contracts described here are a type of binary option, meaning there are only 2 possible outcomes to the option – either the option expires in-the-money or out-of-the-money – hence the options are binary in nature. This regularity in the nature of binary options, together with their investment opportunities, resulted in the launch of binary option trading on the American Stock Exchange in May 2008 and the Chicago Board Options Exchange in June 2008.
An example will help explain the concept more clearly:
Underlying asset: copper
Expiry time: end of the month
Strike price: 284.328
Amount invested: $1,000
Option type: Call
Payout rate: 70%
The buyer purchases a contract granting him the right to purchase copper at a price of 284.328 at the end of the month. If at the end of the month, by the expiry time of the option, the market price of the asset is above its strike price, then the buyer has the right to buy the underlying asset at the lower price, set when the option was granted. The buyer has ended up in-the-money and will receive a payout of $1,700 (70% of his $1,000 investment). Should the asset settle below 284.328 at the end of the month, then the option will expire out-of-the-money and the buyer will lose his $1,000 investment.
So, whether used as a hedging tool in volatile markets or as a profiting tool in calmer markets, binary option trading is being utilized by millions of companies and individuals each year to expand and even protect their trading portfolio.