A binary option is a contract which gives the buyer of the contract the right to buy an underlying asset at a set price at a set time in the future. The underlying asset could be a commodity, index, currency pair or stock. The set price at which the contract is bought is known as the strike price and the set time is called the expiry time. It is the price of the underlying asset at the expiry time which determines the outcome of the option.
So, at the time of buying the contract the investor must make a decision – if he thinks that at his chosen expiry time, the asset’s price will be above the strike price then he purchases a Call option. If he thinks the contrary, that the asset’s price will be below the strike price at the expiry time then he purchases a Put option.
If he buys a Call (Put) option and indeed the price of the asset is above (below) the strike price then he is said to be in-the-money. If however he buys a Call (Put) option but the price of the asset at the expiry time is below (above) the strike price then he is said to be out-of-the-money.
In-the-money options can lead to returns of 60-71%, depending on the platform being used and some even offer a return of as much as 15% if an option expires out-of-the-money.
A possible binary option trade could be:
Underlying asset: Gold
Strike price: 1006.70
Expiry time: end of the day
Option type: Call
What the investor is in-effect saying, is that he thinks that at the end of the day, the price of Gold will be 1006.80 or above. If he is correct, then his option will expire in-the-money and he will receive $850 (70% of $500). Is he is wrong, then his option will expire out-of-the-money and he may receive $75, depending on the platform.