In finance, a binary option is a type of option in which the payoff can take only two possible outcomes, either some fixed monetary amount or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security. They are also called all-or-nothing options, digital options, and fixed return options.
A binary option is simply a 'yes' or 'no' settlement between two people, and involves a certain asset and a particular (short) time period. To better grasp the concept of binary options, you must understand the following terms.
Just like most dealings in the stock-market, binary options are also bound by a certain time period. Only that this case involves a fairly short period. It could be anywhere from a few hours to a week. This time-frame is specified down to the exact minute of the deadline.
The strike price is basically a base-price that settles a binary option. It is based on the current market price of the asset. On the basis of this current market price of the asset, a future price is determined by the buyer.
The cost of buying a binary option from a seller always remains between $0 and $100. It is often considered as a probability of hitting the strike price. For instance, if the probability of hitting the strike price is 0.3, the cost of buying the option becomes $30. However, it could be anywhere between zero to hundred regardless of any probability.
In a binary option, the buyer determines the near-future price of a certain asset. This predicted future price is called the strike price of the option. If the asset has a fifty percent chance of hitting the strike price, the seller will charge $50 for the option. At the same time, a time-frame or expiry time (deadline) of binary option is also set. If at the time of expiry, the asset goes over the strike price, the buyer gets a $100 (always fixed) for every binary option bought. If the strike price is not met, the seller gets $100 per option.
Let us suppose the binary option is sold for $11. If at 02:00 (deadline), the price of the asset is $15.21 (basically anything above $15.20), the buyer gets $100, and the seller goes empty handed.
If the strike price is not hit, which means that the price of the asset at 02:00 pm is $15.19 or anything less than that, the seller gets the $100 while the buyer goes empty handed.
The binary option does not exercise any right over the possession of the asset itself.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!