The word binary means two. A binary option contract is a simple derivative contract with only two possible outcomes.
Depending on the prevailing price of the asset at expiry, the trader either loses his entire investment or receives a pre-determined profit percentage.
Thus, binary option contracts are also referred to as fixed return options (FRO) or all-or-nothing contracts.
The value of a vanilla or regular option traded on an exchange keeps changing in accordance with the changes in the price of the underlying asset.
On the other hand, the value of a binary option contract is determined only at the time of expiry. It can be understood by a simple example provided below:
Let us assume that a buyer purchases a call option contract for gold. Let the price of gold at the time of purchasing the contract is $1200 per ounce.
Let us assume that the expiry time is one day.
At expiry, if the price is above $1200, then the binary call option contract will result in a profit. The holder of the binary contract will receive up to 92% (depending on the broker) of the invested amount. If the price is below $1200, then the binary call option contract will expire worthless. The holder of the contract will lose his entire investment. The inverse is true in the case of put option contract.
As it can be understood, there is no way to exit (some brokers offer such a facility, which we can discuss in later topics) in between.
In the case of vanilla options, which are traded on an exchange, the value keeps changing and a trader can exit any time in between. However, the difference between the price of the underlying asset at the time of entry and exit determines the value of a vanilla option and the corresponding profit or loss. On the other hand, a binary option holder will receive the pre-determined payout even if the price has moved only a few notches favourably in the direction of trade.
The following are the most important differences between vanilla and binary options contract:
Counter parties: The binary options contract is an Over-The-Counter (OTC) product. It is not traded in any exchange (apart from Nadex which offers a totally different structure). The contracts are offered by brokers who act as the sellers (writers). The retail trader will be the buyer (holder) of the contract. In the case of vanilla options, the exchange facilitates or provides a platform for two parties to buy (holder) and sell (writer) an option contract. As it can be understood, the broker (market maker as they are called technically) bears the risk by writing the contract in the case of binary options. In the case of vanilla options, the exchange simply supervises the trade and does not bear any price movement related risks.
Expiry: The binary option contracts are created by the brokers without the involvement of the regulatory bodies. Thus, binary option brokers offer a wide range of expiry periods starting from 30seconds. On the other hand, the structure of a vanilla option contract is determined by the exchange and regulatory bodies. Thus, generally, the vanilla contracts only have monthly expiries. Being an OTC market, the binary brokers are at full liberty to customize products to suit the demand of individual traders. It is not so in the case of vanilla options contract.
Range of options contract: The binary brokers not only offer contracts with multiple expiry periods, but also modifications in the settlement process. For example, in the case of a one touch option contract, as long as the price touches a specific level any time before the expiry of the contract, the trader will receive a fixed amount as profits. However, the vanilla option contracts follow the same standard structure.
Payout: As long as the price keeps moving in the direction of trade, the value of a vanilla option contract will increase. Thus, theoretically, the profits can be unlimited. However, sudden reversals before the expiry time will erode most of the gains. In the case of binary options contract, the trader will receive a fixed profit irrespective of the quantum of price movement in the direction of trade. For example, if a binary options trader has bought a put option contract for gold at $1200, then as long as the price trades below $1200 at expiry, the trader will bag the entire amount allotted as profit. Irrespective of whether the price trades at $1199.99 or $1100, the trader would receive the same fixed percentage guaranteed at the time of entering the contract. In the case of vanilla options, practically, the trader would only incur a loss if the price trades at $1199.99. The reason is that value of vanilla option contracts suffer from time decay. Binary option contracts do not face such an issue.
Other charges: Binary option brokers do not charge any other fees for executing a trade. On the other hand, vanilla option trades would involve exchange related fees and other taxes imposed by the state where the exchange is located. The binary options broker, being a counter party (writer) to all the trades, receives the entire investment of a trader as profit whenever an option holder loses the trade. Thus, the binary options broker does not levy extra charges for executing a trade. Reputed binary options broker mitigates risk through hedging and sophisticated algorithms. This protects them from losing a large amount of money when a trader wins consistently.
Exercise time and rights: The binary option contracts are purely speculative contracts. Thus, the buyer (holder) of the contract will not have any rights to exercise (no demand can be made to buy or sell the underlying asset at the price mentioned in the contract). The contract simply ends in a profit or loss at expiry. The market maker or broker bears the entire risk. On the other hand, vanilla options traded through an exchange offer exercising rights to a trader. The trader can claim his right to buy or sell the underlying asset at or before the expiry.