Binary Option: Definition, How They Trade, and Example

What Is a Binary Option?

Binary options, a financial derivative that allows people to make all-or-nothing wagers on events and asset price changes, have surged in popularity in recent years. But critics, including U.S. regulators who have long cautioned against them, warn that these trades are more akin to gambling than investing and carry a high risk of fraud and losses for unwary consumers.

These options depend on the outcome of a "yes or no" proposition, hence the name "binary." Traders receive a payout if the binary option expires in the money and lose if it expires out of the money. In 2008, the U.S. Securities and Exchange Commission (SEC) approved listing binary options as tradable contracts on exchanges. This move was followed by the Chicago Board Options Exchange and the North American Derivatives Exchange (Nadex), offering standardized binary options to retail traders.

Despite being available on regulated exchanges, much of the trading in binary options in the U.S. goes through unregulated offshore platforms, leading to many scams and frauds. Binary options are banned in many places worldwide, including Australia, Canada, Europe, the U.K., and elsewhere.

How a Binary Option Works

Binary options have an expiry date and time. When that occurs, the price of the underlying asset or event must be on the correct side of the strike price (based on the trade taken) for the trader to make a profit.

A binary option automatically exercises, meaning the gain or loss of the trade is credited or debited to the trader's account when the option expires. That means the buyer of a binary option will either receive a payout or lose their entire investment in the trade—there is nothing between.

An example of a binary option could be as simple as whether ABC's share price will be above $25 on April 22, 2021, at 10:45 a.m. Let's say the client thinks the price will be trading above $25 on that date and time and is willing to stake $100 on the trade. If ABC shares trade above $25 at that date and time, the trader receives a payout per the terms agreed. For example, if the payout is 70%, the binary broker credits the trader's account with $70. If the price trades below $25 at that date and time, the client is wrong and loses their $100 investment in the trade.

As a result, many find binary options easier to understand than regular options—hence their popularity. Because of their risks, there are limits on how much you can trade, for example, about $2,500 on the Nadex options exchange.

Binary Options vs. Vanilla Options

A vanilla American option gives the holder the right to buy or sell an underlying asset at a specified price on or before the option's expiration date. A European option is the same, except traders can only exercise that right on the expiration date. Vanilla options, or just options, provide the buyer with potential ownership of the underlying asset. When buying these options, traders have preset risk, but profits depend on how far the price of the underlying asset moves.

Binary options differ because they don't provide the possibility of taking a position in the underlying asset. They are pure speculation in this sense. Binary options typically specify a fixed maximum payout, while the maximum risk is limited to the amount invested in the option. The underlying "asset" could be prices and events. Some binary options can be closed before expiration, although this typically reduces the payout received (if the option is in the money). 

Binary options occasionally trade on platforms regulated by the SEC and other agencies, but most binary options trading occurs outside the U.S. and is not regulated by U.S. officials. Unregulated binary options brokers don't have to meet a particular standard—or any. Therefore, investors should be very wary of the potential for fraud. Conversely, vanilla options trade on regulated U.S. exchanges and are subject to U.S. options market regulations.

How to Trade Binary Options

When buying binary options, here are the steps:

• Understand the product: You should grasp the basic concept of binary options, how they work, and what determines their payout.
• Broker research: Next, you should search for a reputable broker that trades binary options. For traders in the U.S., it is essential to ensure that the broker is regulated by the SEC. If not, your trades are likely illegal. If you're outside the U.S., you should check local regulations, but many countries ban the practice, leaving you at the mercy of often fraudulent apps that use many timeworn but remarkably effective strategies to keep you wagering your funds away. It's best to avoid platforms suggesting that binary options trades are "low risk," present you with free "bonus money" to sign up or continue after losses accrue, or are overseas. Check with the CFTC and other resources on them. Don't believe they are legitimate just because they look to have free education pages and reviews that some savvy fraudulent platforms have used.
• Set up a demo account: Many brokers offer demo trading accounts where traders can practice binary options with paper or virtual money. This is often said to be a risk-free way of familiarizing yourself with the platform, but many platforms request your contact and financial information, which some offshore platforms have used for identity theft.
• Develop a trading strategy: You should decide on the markets to buy contracts on, the amount to put in, the expiration times, and the type of binary options to trade.
• Set up a live account: After this, you can open a live trading account. This involves providing further personal details, proof of identity, and proof of residence.
• Fund the account: Brokers often require a minimum deposit to start trading. This amount varies among brokers.
• Start trading: You can start buying contracts.
• Monitor and adjust trading strategy: You should continuously monitor your trades and the markets and be prepared to adapt your approach in response to changing conditions.

Fraud Risk with Binary Options

You should be mindful of the potential risk of fraud when trading binary options. It should be noted that many binary options platforms operate outside regulated financial markets. This lack of regulation can lead to a higher risk of fraud since there's no oversight. When the fraud occurs, you'll often be very much on your own.

You must conduct thorough research, verify the broker's regulatory status, and approach binary options trading with caution, fully understanding the risks and the potential for fraud.

Example of a Binary Option

One example entails that the binary option's entry price indicates the potential profit or loss, with all options expiring worth $100 or $0.

The assumption is that stock Colgate-Palmolive (CL) is trading at $64.75. A binary option has a strike price of $65 and expires tomorrow at noon The trader can buy the option for $40. If the price of the stock finishes above $65, the option expires in the money and is worth $100. The trader makes $60 ($100 – $40).

If the option expires and the price of the Colgate is below $65 (out of the money), the trader loses the $40 they put into the option. The potential profit and loss, combined, always equals $100 with a the binary option.

If the trader wanted to make a more significant investment, they could change the number of options traded. For example, selecting three contracts, in this case, would up the risk to $120, and increase the profit potential to $180.

The Bottom Line

Binary options are a type of financial derivative that provides traders with a fixed payoff or nothing at all based on the outcome of a yes or no proposition. The trader bets on whether the price of an underlying asset will be above or below a certain point at a specified time or some other event, leading to straightforward outcomes: either a predefined profit or a total loss of the invested amount.

When the underlying asset is a financial instrument, traders have a unique way to engage with the markets. However, they carry significant risks, mainly because of their all-or-nothing nature and the prevalence of unregulated platforms. As such, before putting your money on the line by trading binary options, it's best to have a good understanding of market conditions, a solid trading strategy, and a clear awareness of the risks involved.