What is a Binary Option?

In this lesson
  • Why are they called “binary options”?
  • The three components of a binary option contract
  • How binary options are really “yes/no” or “true/false” questions

Binary Options – A Yes or No Question

It's binary. It's an option.

We sometimes joke that there are only two things wrong with the term, “binary options.” The first is the word, “binary,” the second is the word, “option.” Let’s break them down:

  • Binary – These contracts can only have one of two values when the contract expires: $100 or $0. You can think of them as all or nothing, true or false, or yes or no. You have been making binary decisions your entire life, so binary options are actually pretty easy to understand.
  • Option – People often think of options trading as complicated and only for “sophisticated” investors. While binaries are a type of option, they are simplified and virtually anyone can learn to trade them. In fact, some experienced traders find binary options challenging at first, because they try to make them more complicated than they are.

So what is a binary option?

A binary option will have one of two outcomes at expiration, either the trader will receive the full value of the contract or they receive nothing. Binary options are short-term, with typical contract lives of one-week or less. They are limited-risk contracts, a concept we’ll cover in depth in the next module. A binary option has three components:

  • Underlying Market
  • Condition and Strike Price
  • Expiration time

Underlying Market – Binary option pricing and settlement is based on an underlying market. In the case of Nadex, the underlying market could be a US or international stock index future, a commodity like gold or crude oil, a currency pair like the Euro-US dollar, the price of bitcoins, or even an economic event like the weekly jobless claims number. For more specifics, please see the module “Underlying Markets”.

Condition and Strike Price – Every binary option has a condition which must be met at a specific price level known as the strike price. At Nadex the condition is phrased as greater than (>) the strike price. For example the name of a binary option contract in gold might begin: Gold > 1250.00 (market, condition, and strike price).

Expiration Date and Time – The expiration date and time is the point at which all trading stops and the market on the binary option closes. If you are holding a position in a binary option to expiration, once it expires and settles you will either receive the full $100.00 payout or nothing. The expiration date and time is a hard close, so unlike milk that has been left in the fridge too long and is still possible to “get on the wrong side of”, once a binary expires you can’t touch it.

If you don’t want to wait until expiration, you can place an order to close your position to limit loss or lock in profit early. Completing our example we could have a binary that states: Gold > $1250 at 1:30 PM on February 30th. (Okay, February has a maximum of 29 days—this example is hypothetical.)

 

The Yes or No Question

 

 

The Yes or No Question:

Add the terms “will”, “be” and “at” to the contract name and you can see the yes or no question it stands for. For example:

 

“Will” Gold “be” > 1250 “at” 4:15PM? Yes or no?
“Will” US 500 “be” > 2000 “at” 1PM? Yes or no?
“Will” EUR/USD “be” > 1.2500 “at” 4:15PM Friday? Yes or no?

If your answer to the question is “yes,” you buy the option. If your answer is “no,” you sell.

Different markets, always the same question:

The key words for any Nadex binary option are “greater than.” For the answer to be “yes” or “true” at expiration, the expiration value of the underlying market must be greater than the strike price. If it is at or below the strike price, the answer is “no” or false. If it is exactly at the strike price, the answer is still "no" and the buyer will get zero while the seller gets the $100 payout at expiration. For more information on settlement and expiration values, see Nadex Settlement Calculation and Expiration Values.

Binary options on the stock index futures and commodities will show a month in parentheses. This is the contract month of the underlying futures contract. (We left it out of the examples above for simplicity.) For additional information on contract months, see Nadex Underlying Markets.

 

At this point you should understand:
  • Why binary options are called “binary options”
  • The three components that make up a binary option contract name
  • How binary options form a simple question about the market

 

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