A binary option is an option where you get paid a predetermined amount if the option expires in-the-money. If the option expires out-of-the-money, you lose your entire investment. This makes binary options different from traditional options (such as vanilla call and put options) where you can not now in advance how large a profit, if any, you will make on your investment if the option expires in-the-money. Because of this characteristic, binary options are also known as all-or-nothing options and fixed-return options.
Recently, some binary options brokers online have started offering binary options that deviate from this traditional model. You can for instance purchase a binary option that will give you a small consolidation payout if it expires near the money.
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Exercising a binary option
You don’t need to actively decide if you wish to exercise a binary option or not. It will automatically exercise when it expires and if it expires in the money you will get paid. There is no underlying asset for you to actually buy or sell.
Yes or no
Binary options are sometimes referred to as yes-or-no options, since your task as an investor is to predict if a certain event will happen or not.
- Will the NYSE:MSFT price be above 63.99 when this binary option expires?
- Will the SPDR S&P 500 ETF (SPY) be below 236.50 when this binary option expires?
- Will the NYMEX:CL.J17.E stay within the 53.30 – 54.30 span throughout the lifetime of this binary option?
Examples of binary option types
- With a High/Low binary option, your task is to predict if the level of the underlying will be higher or lower than the reference point when the binary option expires. This is the most common type of binary option.
- One Touch is a type of binary option that will immediately expiry if a certain price level is reached at any point during the lifetime of the option.Example: This One Touch binary option pays $90 if the price of NYSE:MSFT reaches 63.90 at any point during the lifetime of the option.Example: This One Touch binary option pays $90 if the price of NYSE:MSFT never reaches 63.90 at any point during the lifetime of the option. If the price does reach 63.90, the option will instantly expire and the owner will lose his stake.
- With a Range binary option (also known as an Interval binary option), you need to predict if the underlying will be within a certain range when the option expires.Example: This Range binary option will pay $90 if the price of NYSE:MSFT is within the 63.00 – 64.00 range when the option expires.Example: This Range binary option will pay $40 if the price of NYSE:MSFT is outside the 60.00 – 75.00 range when the option expires.N.B! With some vendors, a range binary option works like a one touch binary option – the underlying must stay within the range for the whole lifetime of the option for the option to pay out. (Or, the underlying must stay outside the range for the whole lifetime of the option for the option to pay out.)
Since binary option vendors are creating their own binary options, almost anything is possible and some vendors do offer highly novel and exotic binary options. It is important to make sure that you fully understand the terms of the option contract before you make any purchase.
Buying binary options
Binary options are typically sold on online platforms run by companies that aren’t exchanges. Examples of this includes eToro and binary.com. There are exceptions though, such as Nadex, a US-based exchange where binary options trading takes place.
When the seller of a binary option also is the writer (creator) of the binary option, and there is no clearinghouse acting as a buffer, it becomes especially important that the vendor is both willing and able to honour all their obligations to their clients. Since non-exchanges are less strictly regulated than exchanges, it becomes extra important for prospective investors to do their own homework and pick binary option vendors carefully.
In some jurisdictions, binary options are regulated as financial instruments. In others, they are regulated by the gambling authority and seen as a type of financial betting.
Examples of binary option regulation
In Cyprus, binary options are classified as financial instruments and regulated by Cyprus Securities and Exchange Commission (CySEC) since May 2012. Binary option platforms based in Cyprus are only legal if they operate under a CySEC license.
CySEC was the first European Union member to classify binary options as financial instruments.
MiFID consumer protection
CySEC is a MiFID-member and binary option vendors based in Cyprus must therefore adhere to both Cypriotic law and the MiFID regulation.
The Markets in Financial Instruments Directive 2004/39/EC (MiFID) is a European Union law targeting investment services across the 31 member states of the European Economic Area. One of the main objectives of the directive is to increase consumer protection in investment services within the European Economic Area.
In 2013, Malta transferred their binary option regulation from Malta’s Lottery and Gaming Authority to Malta’s Financial Services Authority (FSA).
Just like Cyprus, Malta is an MiFID member and binary options vendors based in Malta must adhere to both Maltese law and the MiFID regulation. For more information about MiFID, see the section about Cyprus above.
Malta was the second EU member to classify binary options as financial instrument and regulate them as such. Binary option vendors based in Malta are only legal if they operate with a Category 3 Investment Services License.
The U.S. Securities and Exchange Commission approved exchange-traded binary options in 2008. In May and June that year, binary options trading started on the American Stock Exchange and on the Chicago Board Options Exchange, respectively. Eventually, exchanges such as NADEX and Cantor followed in suit. In 2015, the New York Stock Exchange launched their own version of binary options, the Binary Return Derivatives Option.
Examples of bans and restrictions
- Binary options schemes are banned by Belgium’s Financial Services and Markets Authority since August 2016 due to widespread fraudulent activity.
- In 2016, Autorité des Marchés Financiers (AMF) banned binary option vendor 24Option from trading in France.
- In March 2016, Israel Securities Authority banned binary options trading within Israel, stating that it was essentially gambling, not investment management.
- In July 2016, the U.S. District Court of Northern Illinois banned binary option vendors Vault Options Ltd and Global Trader 365 from operating in the USA and/or selling to US residents.