Binary options offer the ability to wager on a yes-or-no bet, with the trader either winning a sum of money or losing the full stake. Binary options are a different kind of option from what most traders are familiar with, and their structure makes them more like gambling than investing.
Here’s what binary options are, their major risks and rewards, and how they differ from regular options.
What are binary options and how do they work?
Binary options give traders the ability to bet on a yes-or-no proposition. Either a specific event happens or it doesn’t, and the trader wins based on the bet that was made.
A binary option takes place over a specific period of time, after which the outcome of the wager is settled and paid out. While binary options may take place over longer periods of time, they’re often set up with a daily expiration, allowing traders to bet over the course of hours.
Here’s how it works. A typical payout might be $100 if the “yes” side of the wager is achieved. A bettor might purchase this bet for $40 because they think the event will happen, while another bettor thinks the event is unlikely and sells that bet and takes the $40. If the event does happen, the winner gets $100 and the loser must pay $100, losing a net $60, after factoring in the upfront $40 payment. The options exchange takes a cut of the action for itself, regardless of who wins.
The relative returns on binary options adjust to reflect the proportion of bettors on either side of the wager, just the way a bookmaker would set payouts in basic sports betting. If a lot of traders are betting the “yes” side of the question, the price of placing this wager rises toward $100 and the profit falls. In contrast, if an event looks less likely to occur — the “no” looks more likely — more bettors are selling that wager, and the price of the wager falls, raising its potential returns.
When the deadline for the event has passed (say 4 p.m. ET, when the stock market closes for the regular trading day), the exchange managing the binary options settles the wager and distributes the cash from the losers to the winners, and then closes the bets.
If a trader wanted to wager more money on the binary option, they could simply buy or sell more contracts, each of which would have the maximum $100 payout if correct.
An example of a binary option
A binary option with a $100 payout might look like the following: “Will the S&P 500 index finish trading on Monday at 4 p.m. ET at 6,000 or above?”
- If the S&P 500 does close trading at 6,000 or above, then everyone who purchased the “yes” wager will receive the $100 payout.
- If the index doesn’t reach that level, then those who sold the options will keep their cash premium from selling the option. Those who placed the wager will lose their bet.
Let’s say early on Monday that the index dips. The price of the binary option would fall, as fewer traders buy the option and more try to sell it. But then as the day progresses, the index reverses and begins to move up. The price of the option rises as well. Then the index bursts higher around 3 p.m. and hits 6,010. The option rises in value to $93 to reflect the high probability — but not the certainty — that the option ends up in the money at expiration at 4 p.m.
If a bettor bought this late-day trade, they would be risking $93 to win $100, a net gain of just $7, if correct. In contrast, the seller of this option would receive $93 upfront but would still lose $100, or a net $7, if the option finished in the money.
Pros and cons of binary options
Here are the advantages and disadvantages of binary options.
Advantages of binary options
- Quick turnaround: Bettors can regularly find binary options that expire in a day or less, and they can trade options with just hours (or less) left to expiration. For those looking for the rush of gambling, binary options can offer that.
- Ability to multiply your money: Binary options offer the chance to multiply your money if you select an unlikely scenario that does end up occurring. But even in a basic scenario, you could end up doubling your money in the space of a few hours.
- Limited “bite size” bets: You can wager a set amount and know exactly how much you can win or lose with each wager — a maximum of $100 in either case.
Disadvantages of binary options
- High risk: To make the big money here, you’ll have to make high-risk bets on a generally short-term basis. So binary options look a lot more like gambling than regular options.
- Limited markets: Traders have a limited number of venues to use binary options, since most of the best brokers in the U.S. (and the world) don’t offer them, and they’re outlawed in many places. Interactive Brokers offers event trading on futures markets, however.
- Associated with fraudulent activity: Binary options may be traded on unregulated platforms outside the U.S. and other regulated markets, exposing you to the risk of fraud.
How do binary options differ from regular options?
Binary options differ in key ways from regular options:
- Regular options typically have longer expirations: Regular options may have a much longer time to expiration, sometimes over two years, making them less a mechanism for gambling. Of course, zero-day options exist and function much like a short-term bet, too.
- A regular option may end in the ownership of the underlying asset: If you’re trading regular options, you have the potential to exercise the contract and buy or sell the underlying asset, depending on the type of option (call options or put options). With binary options, the wager is settled up at the end of the expiration period and that’s that.
- Regular options offer more strategies: Regular options offer traders more strategies for making money, including strategies for beginning traders, as well as advanced strategies.
The best brokers for options trading can help you get started with regular options and offer you tools to succeed.
Bottom line
Binary options, much like zero-day options, should be thought of as closer to gambling than to investing. They offer the potential to multiply your money in hours at the cost of losing it all, making binary options a high-risk proposition and suitable only for risk-seeking individuals.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
