Let’s design a simple game.
I have a quarter which I will flip at 2:45 in the afternoon. For $50 apiece I will sell you guesses as to whether it come up heads or tails. You can buy guesses right up until the actual coin toss, as many as you like.
Then I toss my coin. For every guess you got right, I’ll pay you $100. For every guess you got wrong, you get nothing.
We have invented a barroom version of the binary option.
What Is a Binary Option?
A binary option is a form of options contract, a financial product (generally) built around the commodities market. In a binary option you take a single position: the price of an underlying asset will be at or above or below a given price by a given time.
Traders who buy a binary option are taking the position that yes, the underlying asset will be at or above the given price by the given time. Traders who sell a binary option are taking the position that no, the price of the underlying asset will be below the given price by the given time.
A binary option always pays either $100 or $0. If the asset’s price is at or above the contract price at expiration, the contract is considered “in the money” and it pays $100. Otherwise it is considered “out of the money” and the contract pays nothing.
Elements of a Binary Option
A binary option has a few basic elements:
- Strike Price – This is the price at which the contract will execute.
- Underlying Asset – The asset whose price is being measured in the contract.
- Expiration – This is the date and time at which the contract will execute.
- Expiration Price – The price of the asset when the binary option executes.
- Position – If you buy a binary option, you will profit if the asset’s expiration price is equal to or greater than its strike price at its expiration. If you sell a binary option, you will profit if the asset’s execution price is less than its strike price at its expiration.
- Bid/Ask Spread – This is the price at which you can sell a given binary option and buy one, respectively. A bid/ask price of $50/$50 means the market has absolutely no guess as to how this contract will resolve. A higher bid/ask price means that traders think it is more likely that this contract will close in the money. A lower one means that traders think this contract will close out of the money. Also known as bid/offer. The difference between the bid and ask prices is the transaction cost which the market itself charges to conduct this transaction, and chiefly reflects the liquidity of this particular contract.
So, take a sample binary option: Steve buys the contract (his position). It says that the price of gold (the underlying asset) will be $52 a gram (the strike price) on January 1 (the execution date). Its market price was $72/$76 (the bid-ask spread), reflecting high confidence that this contract will expire in the money.
On January 1 the price of gold is $53 (the expiration price). Steve’s position has closed in the money and he receives $100. Since he paid $76 for this binary option, Steve’s total profit is $24.
How a Binary Option Works
The profit for a binary contract depends on the trader’s position. Traders buy a contract profit if the price of the asset meets or exceeds the strike price at expiration. If they’re right, they receive $100 and their profit is the difference between that $100 and what they paid for the contract. If wrong, the trader’s loss is the difference between their $0 return and the price of the contract.
Traders who sell a contract have taken the position that the underlying asset’s price will be below strike price at expiration. If they’re right, they pay $0 and their profit is the price that they charged to sell this contract. If they’re wrong, they pay $100 and their loss is the difference between $100 and the price they charged.
Since the payoff of a binary contract is always either $100 or $0, the price of the contract is also always in this range. (It would make no sense to buy a contract for more than $100, since you would lose money even if the contract paid off. Nor would it make sense to sell a contract for less than $0, since that would mean paying someone for the chance to potentially pay them $100 later.)
It’s important to note that, like all options contracts, a binary contract can be built around virtually any underlying asset. While most traders use commodities such as gold, coffee or lumber, you can build binary contracts around stocks, cryptocurrencies, bonds and any other tradable asset so long as it has a measurable market price.
The time scale of a binary option can vary widely. Some can last for months before the expiration, while others will be built to expire in hours or even minutes.
A Binary Contract in Action
To understand this, let’s look at a binary contract in action.
Steve enters into a binary contract for the price of coffee beans. It says that on July 15 at 2:45 p.m. the price of coffee will be at or above $1.40 a pound. The bid/ask spread is $45/$47 (the price at which the market will buy this contract from Steve and the price at which it will sell it to him, respectively).
Let’s say that Steve buys this contract and pays $47 for it (the ask price). In this case, he believes that at 2:45 on July 15 the price of coffee beans will be at or above $1.40 per pound. Now one of two things will happen:
- The contract expires and coffee costs $1.40 per pound or more. Since Steve bought this contract, he will make $100. His profit will be $53 (the $100 payment minus the $47 he paid for the binary option).
- The contract expires and coffee less than $1.40 per pound. Since Steve bought this contract, he will make nothing. He will lose the $47 that he spent on the contract.
On the other hand, let’s say that Steve sells this contract. If he does, he’ll collect $45 (the bid price). Now his risk is flipped. He believes that at 2:45 on July 15, coffee will cost less than $1.40 per pound. In this case, again, one of two things will happen:
- The contract expires and coffee costs $1.40 a pound or more. Since Steve sold this contract, he now owes $100. He will lose, in total, $55 (the $100 that he will pay on the contract minus the $45 he received for it).
- The contract expires and coffee costs less than $1.40 a pound. Steve will pay nothing, and will keep the $45 he received for selling this contract as profit.
Binary Means Binary
There’s an important point to take from our example above: The actual price of coffee does not matter.
A binary contract pays the same amount of money regardless of how much the price of its underlying asset moves (or fails to move). The only relevant metric is whether the price manages to meet or exceed the strike price. This is why traders call these products “binary contracts,” because there are only two possible outcomes for any given contract.
So, in our example, Steve’s contracts would have the same outcome if the price of coffee soared to $5 per pound or crashed to 10 cents. The only question is whether the price was at or above the contract’s price when it expired.
Finally, it is worth noting that some markets handle seller contracts differently.
A standard binary option will have the risk profile described above. A buyer risks the up-front price of the contract, with the chance of profit if the contract closes in the money. A seller receives the up-front price of the contract, with the risk of having to make the contract’s $100 payment if it closes in the money.
However some markets use the same structure for both buyer and seller contracts. In these markets, a seller will pay the bid price for their contract and will receive $100 if the asset’s price is below the strike price at expiration. In these markets, the market itself makes the payments. Sellers and buyers have identical positions, with the only exception being the conditions under which their contract pays out.