Understanding Binary Options

In layman terms, traditional or vanilla options are contracts that give right to buy or sell at a future date at a given price. The point to understand here is, these are rights and not obligations. The owner of the option has choice to execute it on or before the expiry date.

In 2008, other exotic options started trading in the market called as Binary Options. These are also known as digital or options with fixed returns. To trade in binary options, one need not be genius or have any previous experience in the market. This has made them very popular in a short span of time.

Similar to traditional options, binary options also have underlying asset, which can be currency, commodity, index, stock etc. As the name Binary suggests, these options have two outcomes. Either True or False. In case the condition is met and the outcome is true, the buyer gets the fixed amount. Else, the buyer loses all the money invested.

Let us understand this with a simple example:

Suppose you think the price of silver will decrease today. The current price of silver is $16. The dealer gives you an option to buy at $100 with pay-out of 65%. At the end of the day, the price of silver closes below the current level at $15.80. In a simple, Hi/Low option, as your prediction was correct you will gain the amount that was fixed at the start of the deal along with the initial amount that you have invested i.e. $100 + $65.

If the price of silver closes above the current level, say at $16.25 you lose all the money invested.So, your loss will be $100.

Characteristics of Binary Options:

1. They are very simple in understanding as not many strategies are involved.

2. These options have only two outcome, in the money or out of the money.

3. The gain and loss amount is defined at the beginning of trade. Either one gets the pay-off or nothing.

4. The risk and reward both are limited in binary options.

5. Underlying commodity is just for reference purpose.

6. The price movement of underlying security does not affect the pay-off.

7. The expiration time of contract varies from 60 seconds to one year. Wide range of expiry options make them lucrative for short term investors.

8. The option can be exercised only once, i.e. at the time of expiry.

9. No margin money or fees are involved.

10. In India, SEBI has no laws or regulations for these options.

As binary options are mostly based on predictions and are quite straightforward, many newcomers are attracted to invest through these. However, these are traded by brokers over internet. As these are not recognised on the exchange they carry higher risk of fraud and failure. Many countries do not approve trading of Binary options as they think they are very speculative in nature.

Just like any other investment avenue, there is some risk associated with binary options as well. But, in a broader view, its simplicity and quick returns outweighs the risks.