Also known as digital options or fixed-return options, binary options belong to a special class of exotic options in which the payoff is either a fixed predetermined amount or nothing at all.
For the common high-low binary option, the trader buys a binary call option if he thinks the price of the underlying asset will go up above the current market price or if he thinks the underlying asset price will go down, then he will buy a binary put option. If his assessment is correct, he will receive a payout. Otherwise, he loses the initial investment.
As binary options have fixed returns, it doesn’t matter how high or how low the price of the underlying has moved past the strike price. The payout is also fixed and known prior to entering the trade. Also important to note is the fact that the payout for a successful binary trade is usually only about 70% to 80% of the investment put into the trade.
Binary options also typically have very short expiration times ranging from as fast as 60 seconds to just a few weeks.
A binary options brokerage is offering 85% payout for the binary call option on EUR/USD which is currently trading at $1.30.
After tracking the price movement of EUR/USD for the past hour, a binary option trader believes that the price will rise over the next 5 minutes and decides to invest $100 to purchase a binary call option on EUR/USD expiring in the next 5 minutes.
If EUR/USD goes up to say $1.31 five minutes later, the investment pays off and the traders earns a profit of 85% of his initial investment, which is $85.
However, if the price of EUR/USD drops down to say $1.29 instead, the trader will have lost his initial investment of $100.
Note that it does not matter whether the price of EUR/USD skyrocketed up to $1.40 or flash crashed below $1.00, both the profit and loss will be fixed at $85 and $100 respectively.
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