A binary option (aka digital option) has a payout that depends, by definition, on whether a condition is true or false. Every other feature of the binary option depends on the particular binary option contract, which, in turn, depends on the writer of the contract, or, if the contract is standardized, as it is on an exchange, then the exchange generally determines the terms of the contract. Binary options can be used to profit from speculations of where the market will not move, or on ranges, breakouts, economic events, and other types of events.
In the United States, as of 2014, only the following exchanges are legally permitted to offer binary options to United States (US) retail customers:
- Cantor Exchange LP
- Chicago Mercantile Exchange (CME Group), Inc.
- Chicago Board Options Exchange (CBOE)
- North American Derivatives Exchange, Inc., otherwise known as NADEX.
Since NADEX is the most popular platform for trading binary options in the US, the following discussion will focus on the binary options offered by that exchange.
Although a binary option is classified as an option, it differs in significant ways from plain-vanilla options, such as stock options. For one, there is no distinction between puts and calls. Although the CBOE offers some binary options with puts and calls, it is not a useful classification, since a binary option is based on whether a condition is true or false. Often, the condition is whether the underlying asset will reach a certain value or not. A call based on a stock option pays off if the underlying stock price exceeds the strike price of the call. A put pays if the underlying stock price is less than the strike price. In the case of the binary option, the seller of the binary option will profit if the price is below the strike price and the buyer of the binary option will profit if the price of the underlier is at or above the strike price. So, if a trader did expect the price of the underlying to decline, then, instead of buying a binary put, the trader would sell a binary option; if the price was expected to rise, then the trader would buy the binary option. Thus, nothing is gained by classifying a binary option as a put or call.
Binary Option Contracts
There are 4 primary components of a binary option:
- underlying instrument
- strike price
Binary options offered by NADEX are based on 4 different asset classes:
- stock index futures
- commodity futures
- spot forex
- economic data releases.
CBOE offers binary options on the S&P 500 index, the volatility index, and credit events, such as bankruptcy of a particular organization. Economic data releases are an unusual underlier for an option, but NADEX offers them. For instance, with jobless claims, a position can be taken on whether jobless claims will be above or below the consensus.
The strike price is the price or value that the underlying asset must equal or exceed for the holder of the binary option to profit.
On NADEX, binary options have terms of hours, 1 day, or 1 week. For hourly options, there are several expiration times, which are much shorter than for plain-vanilla options:
- Intraday: 11 AM, 12 PM, 2 PM, and 4:15 PM EST
- Daily: 4:15 PM
- Weekly: every Friday at varying times depending on the asset.
The available strike prices of a binary option center around the current price or value of the underlying. Because the underlying has less time to move, binary options with hourly expirations have a very narrow range, daily options have a slightly wider range, while weekly options have the widest selection of strike prices to choose from, since the underlying can move more, up or down, over the course of the week.
The payout of each binary option is either $0 or $100. The premium is the current market price of the option, which will vary from $0 to $100; the long trader pays the premium to the short trader. The long trader's maximum loss is equal to the premium; the short trader's maximum loss is equal to $100 minus the premium.
Trading Binary Options
Stock options have both intrinsic and time value. With traditional options, such as stock options, the time value will never subtract from the intrinsic value, which is the amount that the option is in the money; time value may be 0, but an option that is in the money will not be less than its intrinsic value, since it can be immediately exercised or offset for at least its intrinsic value. Binary options cannot be exercised before expiration, so there is only time value — a binary option does not have an intrinsic value, because even if it goes into the money, it cannot be exercised to realize that value. What value a binary option has depends on the probability that it will be in the money at expiration. If the option is in the money, then it can easily go out-of-the-money before expiration. Although a binary option cannot be exercised, since the holder is not given any rights in regard to the underlying asset, it can be offset by reversing the transaction: so a short trader would buy back the binary option, while the long trader would sell it before expiration to close his position.
The price of a binary option varies from $0 to $100. Both the risk and the reward of binary option can be no greater than $100, both for the short trader and the long trader. Like other options, binary options have time value: the greater the amount of time remaining until expiration, the more expensive the option will be, since there will be a greater probability that the option will be in the money at expiration.
The price will depend on how close the underlying is to the strike price. Those who buy a binary option will want the underlying to close above the strike price so that they can receive the $100 settlement; conversely, short sellers want the underlying to close below the strike price so that they can collect the $100 payment.
Therefore, as expiration nears, a binary with a strike price above the underlying price will move toward $0, while a binary option with a strike price below the current underlying price will move toward $100. Binary options that are likely to remain in the money will quickly increase in price to $100, since those already holding do not want to sell while others want to buy. If the underlying asset price drops below the strike price, then the binary option will quickly move to 0, since the shorts will want to sell, hoping to recoup at least a small premium, but other traders will not want to buy.
On a long trade, the maximum profit is $100 minus the premium paid for the option; the maximum loss is the premium paid for the option. The collateral that must be deposited for a short trade is equal to $100 minus the option premium. In other words, the short trader must pay the amount of the maximum loss. For the short seller, the premium remains part of the collateral until the contract either is closed out or expires.
A commission is generally charged to either enter or exit the contract. There may also be a settlement fee for the winner if held until expiration and there may even be a fee for setting a limit order.
Binary option quotes will list the underlying asset, strike price, expiration time and date, and the bid and offer prices. The bid price is what the trader would receive by selling the option, while the offer price is the price that the trader must pay to buy the option. The offer is always higher than the bid price, and the difference is called the spread. Because the volume of binary option contracts traded on the exchange is relatively low, the bid/offer spread can be sizable.
If the option trader wins the $100, then he will generally be notified by email. A settlement fee must be paid for a winning settlement at expiration; if the binary option expires worthless, then there is no settlement fee.
Binary Option Accounts
Some binary options can be traded using a regular brokerage account, but there are accounts available specifically to trade binary options. Binary options were originally traded over-the-counter (OTC), but, in the US, OTC options cannot legally be offered to retail customers. Furthermore, there has been considerable amount of fraud concerning broker-dealers of binary options. Potential investors should use FINRA BrokerCheck to do background checks on brokers before funding an account.
However, a trader who wants to trade binary options can open an account directly with NADEX, which, in 2014, has the widest selection of binary options and is one of the exchanges sanctioned by the Commodity Futures Trading Commission (CFTC). Binary options offered by CME Group and by the CBOE differ substantially from the binary options offered by NADEX, which are described in this article, but they can be traded from a regular options account.
Binary Options Trading as a Form of Gambling
Some people consider the trading of binary options as a form of gambling. Of course, all trading can be considered a form of gambling, but the characterization may be more apt in the case of binary options. Consider the binary options traded on NADEX. With terms of 1 week or less, it is hard to characterize binary options as an investment, or even as a hedge, which is a common reason for using other types of options. Furthermore, the bid/ask spread is wide, judging from their own tutorial on how to place an order. For instance, the NADEX tutorial gives an example of placing a day trade on EUR/USD (https://www.nadex.com/learn-to-trade/binary-options.html, accessed on 8/22/2014), betting that it will close above 1.2980 at 3 PM, when the underlying was at 1.29725. The bid price was at $43.50 and the ask price was at $49, a spread of $5.50, which I think is pretty hefty when you consider that the maximum long profit on that trade is $51; the maximum short profit = $100 – $43.50 = $56.50. So the spread is more than 10% of the possible profit! On top of that, a commission of $.90 per lot is charged, and if the option expires in the money, then an additional $.90 is charged as a settlement fee. That's $1.80 in commissions for a trade with a maximum profit of $51 or $56.50. At least in forex, dealing desk brokers who earn their money through the spread don't charge a commission, while ECN brokers charge a commission, but then your order is displayed to others on the same network, which generally yields a smaller bid/ask spread. On NADEX, I cannot readily ascertain, by perusing the information on their website, whether the limit orders are even visible to other participants or whether NADEX operates much like a dealing desk broker, setting the bid/ask prices itself.
It is probable that trading binary options will be addictive to some people, and, of course, that is the main reason for offering a trading platform for them, but in their present form, they are neither an investment nor a hedge.