Constituents of a binary option contract

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Constituents Of A Binary Option Contract

In a binary options trade, once a trader selects a suitable asset (equity, commodity, currency or index) and forecasts the probable direction of price movement, a call or put option should be purchased. To do so, a trader should have a clear understanding of the technical lingo, which is unique to options trading.

Asset: Any item, which has a money value, is referred to as an asset. An asset can be tangible or intangible. As far as binary options trading is concerned, the asset can be an equity (common stock of a company), commodity (precious metal, wheat, rice, sugar, cotton, zinc, lead, etc.,), index (Dow Jones, Nasdaq, FTSE, DAX, etc.,) or currency pair (USD/CHF, EUR/USD, AUD/USD, NZD/USD, etc.,).

Expiry: It is the time for which a contract remains valid. A contract becomes void as soon as the expiry time passes by. In the case of a binary options trade, the value of an asset is calculated based on the existing price at the end of last second of the expiry time. For example, if the expiry time is 60 minutes, then the prevailing price at the end of 59 minutes and 59 seconds is used to determine the outcome of a trade.

Strike price: It is the reference price based on which the profit or loss is calculated in a binary options trade. For example, let us assume that a binary options trader expects the price of crude, which is currently trading at $35, to go up. He proceeds to purchase a binary call option contract of crude priced at $40. Then the strike price for this trade is $40. At expiry, if the price of crude is $40.01 or more, then the buyer (option holder) will receive the stipulated amount.

Option Alpha

Premium: It is the difference between the prevailing market price and the price paid to the writer of an options contract. It is a term regularly used in vanilla options. The term can be understood clearly from the following example:

A trader anticipates a decline in the price of Apple (AAPL) stock to $95. Let the prevailing share price of Apple is $101.15.

A vanilla options trader would purchase a put option contract with strike price of $95. Let the premium for the strike price is $0.10. Thus, for buying 20 lots (1000) of Apple put option contract, the investment required is $100 ($0.10 * 1000). Let the expiry period is one month. If the traded price of Apple is $94 at expiry, the premium would have risen to approximately $1. The trader can sell the put option contract for a profit of $100.

If the traded price of Apple is $94.99, then, theoretically, the premium would be only around a cent. Thus, after deducting the exchange related charges, the buyer (options holder) would end up in a small loss.

For the same scenario, a binary options trader would decide the investment first. Let us assume that the binary options trader is willing to take a risk of $100. The binary options trader would then proceed to purchase a binary put option contract with a strike price of $95 from a binary broker offering a payout of 92%. Let the expiry date is one month. If Apple trades at even $94.99 at expiry, then the trader’s account will be credited with $192 [$100 (investment) + $92 (payout).

In-the-money: An in-the-money option contract will have a value more than $0 at expiry. For example, if a binary option trader has bought a put option contract for crude with a strike price of $35, then the contract is said to be in-the-money, if the price of crude is at least a notch below $35 at expiry. To put it simpler, a profitable trade is usually referred to as in-the-money contract.

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Out-of-money: At expiry, an out-of-money option contract will have no value. For example, if a binary option trader has bought a put option contract for crude with a strike price of $35, then the contract is said to be out-of-money, if the price of crude is at least a notch above $35 at expiry. To put it simpler, a loss making trade is generally referred to as out-of-money trade.

Binary Option Contracts Uncomplicated

A binary option contract is simply a true/false or yes/no statement. The main consideration options traders need to make is whether they believe the statement will be true at settlement, in which case they should buy the contract, or if it will be false, in which case they should sell.

After consulting charts to determine a position, whether buying or selling, the Nadex demo and live platform can provide numerous contracts to fit the chosen trading position. Click on a listed contract and a ticket will open. The following image illustrates this example.

The statement is EUR/USD >1.1161 (3PM): The EUR/USD will be greater than 1.1161 at 3 PM ET. Since the indicative is 1.11654, the statement is already true. Notice the max loss (risk) and max profit (reward). If the contract was bought and the market didn’t go up anymore, simply staying where it is, this trade would be profitable.

As long as the statement is true at settlement, the market can stay where it is or move slightly up or down and the bought contract will remain profitable.

Why are some contracts priced around 70 while others are priced about 20? On the ticket above, notice its offer price of 77.50 is closer to 100 because the statement is already true. This is an in-the-money (ITM) binary because the market is already above the statement or contract price.

Looking at the image above, notice that the current market (indicative) is 21056.2. The >21043 contract is already true since the market is above that number. In order for the >21079 contract to be true, the market needs to move more than 20 points in the next 70 minutes. For the >21043 contract, there is a much higher probability that the statement will expire true because it is already true. The >21079 contract has a much lower probability of expiring true because it requires the market to move.

Binaries pricing does not take into account the direction of the market, where the market is going, what strategies are being used or what charts and indicators may show. It is merely from a pricing and probability standpoint. It compares the current market (indicative) to the strike price and then comes up with a pricing model. The pricing model can serve as a probability or a percentage.

The average of the bid and offer prices gives a percentage or probability of the binary expiring above the strike. When selling a contract, it is good to use that average in reverse to say that the binary has that much of a percentage or probability of being false. To clarify, suppose a binary is sold for $20. It has a 20 percent chance that the statement will be true and an 80 percent chance that the statement will be false. In this example, there is a higher percent chance of being right if the binary contract is sold.

Binary Option

What is a Binary Option?

A binary option is a financial product where the buyer receives a payout or loses their investment, based on if the option expires in the money. Binary options depend on the outcome of a “yes or no” proposition, hence the name “binary.” Binary options have an expiry date and/or time. At the time of expiry, the price of the underlying asset 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 on the trade is automatically credited or debited to the trader’s account when the option expires.

Binary Options Outside the US

Basics of a Binary Option

A binary option may be as simple as whether the share price of ABC will be above $25 on April 22, 2020, at 10:45 a.m. The trader makes a decision, either yes (it will be higher) or no (it will be lower).

Let’s say the trader thinks the price will be trading above $25, on that date and time, and is willing to bet $100 on it. 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 was 70%, the binary broker credits the trader’s account with $70.

If the price trades below $25 at that date and time, the trader was wrong and loses their $100 investment in the trade.

Key Takeaways

  • Binary options depend on the outcome of a “yes or no” proposition.
  • Traders receive a payout if the binary option expires in the money and incur a loss if it expires out of the money.
  • Binary options set a fixed payout and loss amount.
  • Binary options don’t allow traders to take a position in the underlying security.
  • Most binary options trading occurs outside the United States.

Difference Between Binary and Vanilla Options

A vanilla American option gives the holder the right to buy or sell an underlying asset at a specified price before the expiration date of the option. 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 fixed risk, but profits vary depending on how far the price of the underlying asset moves.

Binary options differ in that they don’t provide the possibility of taking a position in the underlying asset. Binary options typically specify a fixed maximum payout, while maximum risk is limited to the amount invested in the option. Movement in the underlying asset doesn’t affect the payout received or loss incurred.

The profit or loss depends on whether the price of the underlying is on the correct side of the strike price. Some binary options can be closed before expiration, although this typically reduces the payout received (if the option is in the money).

Binary Options and Regulation

Binary options occasionally trade on platforms regulated by the Securities and Exchange Commission (SEC) and other regulatory agencies, but most binary options trading occurs outside the United States and may not be regulated. Unregulated binary options brokers don’t have to meet a particular standard; therefore, investors should be wary of the potential for fraud. Conversely, vanilla options trade on regulated U.S. exchanges and are subject to greater oversight.

Real World Binary Options Example

Nadex is a regulated binary options exchange in the United States. Nadex binary options are based on a “yes or no” proposition and allow traders to exit before expiry. The binary option’s entry price indicates the potential profit or loss, with all options expiring worth $100 or $0.

Let’s assume stock Colgate-Palmolive Co. (CL) is currently trading at $64.75. A binary option has a strike price of $65 and expires tomorrow at 12 p.m. 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 Nadex binary option.

If the trader wanted to make a more significant investment, he or she 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.

Non-Nadex binary options are similar, except they typically aren’t regulated in the United States, often can’t be exited before expiry, usually have fixed percentage payout for wins (whereas Nadex payouts fluctuate based on the price paid for the option) and may not trade in $100 increments.

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Guide How To Become Binary Options Trader
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