A classic binary option only has two outcomes: you win or you lose. When you purchase a classic binary option, you know exactly how much you will be awarded if it expires “in the money”. If it doesn’t expire in the money, you lose your initial investment – nothing more and nothing less. With a classic binary option, there is no sliding scale for profits nor for losses. This is one of the reasons why binary options have become so popular.
Example of how a binary option can work
You believe that the price of NASDAQ: AAPL is on its way up. Buying the actual shares would cost you $119.04 per share, plus transaction costs. Instead, you purchase a $100 binary option that promises you a $300 award if the price of NASDAQ: AAPL is above $120 72 hours from purchase. This is an above/below binary option, which is a slight variation of the classic up/down binary option.
72 hours later, the NASDAQ:AAPL price is $121.04. You get your $300 award and has made a $200 profit in 72 hours.
Should you have bought shares instead? The share price rose from $119.04 to $121.04. That is $2 per share. To make a $200 profit, you would have had to purchase one hundred shares. That would have tied up $119.04 x 100 = $11,904 of your bankroll. Also, you would risk losing it all. If the price of the shares started to plummet, and you needed to realize your loss, that loss could have been huge. With the binary option, you knew that you could never lose more than your initial $100 investment.
In the scenario above, you managed to find a binary option with a very handsome 200% payout. Payouts like that is rare for classic binary options, but it does exist. You probably purchased this binary option in a market situation where “all the experts” believed that the NASDAQ:AAPL was on its way down. Normally, a majority of available classic binary options pay somewhere between 70% and 95% when they expire in the money. If you want higher payouts than that, you should take a look at some more exotic binary options – such as the no-touch binary option.
Purchasing a classic binary option
You are going to need an account with a binary options broker if you want to buy binary options. You can compare binary options brokers here. Here are a few important aspects that you will need to decide when you make your purchase:
- Which underlying asset class do you want? Examples of commonly utilized classes are equities, currencies and commodities. Using an index as underlying is also popular among binary option vendors online.
- Which exact underlying do you want? In the example above, the underlying was NASDAQ: AAPL (Apple common stock shares traded at Nasdaq).
- When do you want the binary option to expire? Some binary options have a very short life-time, e.g. 60 seconds after purchase. Others will last considerably longer, e.g. 7 days or 30 days into the future from the moment of purchase.
- Do you think the price of the underlying will be higher when the binary option expires than at the time of purchase? Or will it be lower? Or the same?
- How much money are you willing to risk? Many binary option vendors will allow you to tailor this number to your exact preferences. Instead of offering “ready made” binary options for certain set amounts, they let you enter the exact amount of money you wish to risk and create a binary option for that exact amount.
Examples of binary options
Up/Down binary option
Do you think the value of the underlying will be higher when the option expires than when you purchase the option? Buy an UP binary option. Do you think it will be lower? Buy a DOWN binary option.
Above/Below binary option
With an ABOVE binary option, the value of the underlying must be above a certain predetermined level when the option expires for you to get paid. With a BELOW binary option, the value of the underlying must be below a certain predetermined level when the option expires for you to get paid.
One-Touch binary option / No-Touch binary option
With the two binary option types described above, the determining factor is the value of the underlying exactly when the option expires. A One-Touch binary option is different, since it takes the entire lifetime of the option into account.
Example: You purchase a One-Touch binary option that will pay out if the value of the underlying reaches $20 at any point during the lifetime of the binary option.
A No-Touch binary option works the same way, but now it is necessary for the underlying not to reach a certain level during the lifetime of the option for you to get paid.
Example: You purchase a No-Touch binary option that will pay out if the value of the underlying never reaches $25 at any point during the lifetime of the binary option.
Range binary option
For you to get paid on an In (inside range) binary option, the value of the underlying must be within a certain range when the option expires.
Example: You purchased an In binary option that will pay out if the value of the underlying is above $50 and below $60 when the option expires. When the option expires, the value of the underlying is $52 which means you get paid. If it for instance had been $48 or $68, you would have lost your money.
For you to get paid on an Out (outside range) binary option, the value of the underlying must be outside a certain range when the option expires.
Example: You purchased an Out binary option that will pay out if the value of the underlying is outside the $100 – $120 range when the option expires. When the option expires, the value of the underlying is $122 which means you get paid. If it for instance had been $98, you would still have been paid since $98 is also outside the range.
Range boundary options are also known as boundary binary options.