What Constitutes a Binary Options Contract

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What Constitutes a Binary Options Contract?

A binary option trade is actually a contract. Contracts have certain features, as well as, terms and conditions which govern them. A binary options contract will therefore have certain features and specifications.

So what are those features and specifications that are common to binary options trades?

Expiry date

All binary options have a date or time that they expire. At this time, the value of the asset on expiry (expiry value) is assessed against the value of the asset when the trade was made (entry price). If a directional binary option (Up or Down) was the trade that was made, the outcome of the trade based on what the expiry value is versus the entry price will determine if the trade is settled as a profit or loss.

Expiry value

Also known as the settlement value, this is the value of the option contract when the trade expires. The settlement value determination varies on US and European binary options platforms. On US platforms, settlement value is either 0 (losing trades) or 100 (winning trades). On European platforms, settlement value is the price at which the option ends, with payment being made if the settlement value is higher than market price (CALL trade) or lowr than market price (PUT trade).

Strike price

The strike price is the target price used in determining the outcome of the trade. The strike price is most relevant in the Touch trades (Touch/No Touch or One Touch), the Ladder trades and the Tunnel trades. By comparing the expiry value to the strike price, the trade is shown to either be in the money or out of the money. Some trades have one strike price (Touch) while others have multiple strike prices (Ladder).

Underlying Asset

Every binary options contract is traded on a financial asset. This is the particular market, exchange, commodity, currency or stock that is being traded. It is the volatility of the underlying asset that provides the basis for trades. The assets are grouped into four classes:

  • Stocks
  • Stock Indices
  • Currencies
  • Commodities

Underlying Market Price

This is the real-time market price of the asset traded in the underlying contract. For most trades, the market price is used as the benchmark price for the trade (strike price). Some online platform allow traders to choose a different price as strike price (e.g. in the High/Low trade on BetonMarkets).

Contract

This is the basic unit of an options trade. In conventional options, a contract is made up of 100 units of the asset, but in binary options, whatever the trader has chosen as investment amount will serve as the contract value. For NADEX, one lot of the asset represents a contract.

The bid price is the premium price that a trader will pay to the dealer for opening an option to sell a contract, or to close a buy order. This feature is used in NADEX and on AnyOption to trade the Binary 0-100 contract.

This is a term used to define a bet strategy which is based on an expectation that the price of the underlying asset will drop. A trader will use a PUT on an open sell order.

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This is the premium price that a trader will pay for buying a position from the dealer. This is equivalent to placing a CALL trade on a position anticipating an increase in the price of the underlying market. It is also the price paid by a trader who has an open position to sell and wants to close it out.

Spread

This is the difference between the bid price and ask price. It is the broker’s compensation. In any market, an increase in trade volume or increase in liquidity will tend to cause the spread to narrow. The reverse is also the case: little volume and liquidity will cause spreads to widen. In NADEX binary options spreads are interpreted in the context of the total return.

Commission Fee

This is a service charge that the trader pays on each transaction in the market. This is usually a fixed fee as opposed to the spread which is variable. NADEX charges $1 per transaction while Cantor Exchange charges $0.9 per fill on a price you make and $0.9 per in-the-money result. Different firms charge different commissions. Online binary options brokers do not charge separate commissions. The charges are billed into the trade.

Conclusion

These terms explained above are the key features of binary options contracts, and they will be encountered whether the trader operates on NADEX or on one of the regulated and uregulated online binary options platforms. As a trader it is your responsibility to understand what these terms mean in practice. Most brokers should provide this information in their help section together with additional information on how to trade on their platform.

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.

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.

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