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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 , only the following exchanges are legally permitted to offer binary options to United States US retail customers:. 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. In most cases, 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. 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. For hourly options, there are several expiration times, which are much shorter than for plain-vanilla options:.
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.
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: Like other options, binary options have time value: The price will depend on how close the underlying is to the strike price. 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.
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 referred to as the spread. A settlement fee must be paid for a winning settlement at expiration; if the binary option expires worthless, then there is no settlement fee. Some binary options can be traded using a regular brokerage account, but there are accounts available specifically to trade binary options.
Furthermore, there has been considerable amount of fraud concerning broker-dealers of binary options. However, a trader who wants to trade binary options can open an account directly with NADEX, which, in , has the widest selection of binary options and is one of the exchanges sanctioned by the Commodity Futures Trading Commission CFTC.
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. 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.
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. Binary Options Trading as a Form of Gambling Some people consider the trading of binary options as a form of gambling.