Understanding Binary Options

Article Written By: Gavin Wyatt

Among the options available to stock traders is the binary kind of option. It is also called the digital or fixed return option, and has only in recent years become a more public exchange-traded option. Binary options, simply put, reward the investor for a correct estimate of future stock price. An incorrect estimate causes the investor to lose his entire investment.

Because of this scenario, these options are called binary or digital. Also, the reward is ascertained at the outset, usually as cash remuneration, and thus the fixed nature of the return. The usual trading mode for binary options is the Over-the-Counter, or OTC, market. Even here the exchange of binary options is indirect, often involving more complex instruments such as hedges and corporate treasuries.

The stock that is being targeted is also not the usual common share, but instead can be a commodity such as metals, or currencies. Other instances of binary options include the rates market and popular indices. In industries where production can be widely affected by natural elements, hedging-based binary options are common.

For example, an agricultural company may hedge against unseasonal rainfall, and the options trader would then compute a pay-off or compensation (in this case) based on the impact. The binary option in this case would be a put when production falls below a certain level, and if this occurs then the losses that would have been incurred owing to low production could be marginally compensated by gains from trading the option.

Another necessity for binary option targets is the absence of revisions. Trading in binary options tends to be fairly liquid, with payouts being made almost instantly and usually in cash units rather than asset units, and so if the outcome is subject to revision it could complicate the transaction between agents and investors. The fallout is invariably a decrease in takers for that option.

Again, extreme volatility also makes binary options trading lucrative as it undermines any predictive algorithm. Such volatility can be due to any number of economic conditions and this only hinders any estimation that may be made. Currencies from new or developing markets are therefore good binary targets as they may fluctuate widely against more established or stronger currencies.

Some terminology has evolved into the common speech regarding binary options. A positive result, whether a call or a put, is often referred as being in the money. The alternative is termed being out of the money.

The target is called the strike price. The time at which the target is evaluated is called the maturity date. The conditions of the trade also define whether the pay-off is awarded on reaching the strike price or crossing it. In the common options a call is when the price is at or above the strike price, whereas a put is strictly below.

However, this may vary. Since the black-and-white scenario always looks at above strike price or below, the at strike price scenario can be a shadow area needing careful scrutiny by the investor.

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