Binary options are a type of financial derivative that provides traders with a simple way to speculate on the price movement of various underlying assets, such as stocks, currencies, commodities, or indices. Unlike traditional options, binary options have a fixed payout and a fixed expiration time.
How do binary options work
Binary options derive their name from the fact that they offer only two possible outcomes: either a fixed payout if the option expires “in the money” or a total loss of the investment if the option expires “out of the money.” The trader must predict whether the price of the underlying asset will be above or below a certain level (the strike price) at the expiration time (usually between a few minutes and a couple of days).
When the trader gets it right, he is “in the money” and gets a predetermined payout. This payout is known before the trade is executed. However, if the trader’s prediction is incorrect, and thus the option expires “out of the money,” the trader loses his entire investment. With binary options a trader doesn’t need to know how much the price will rise or fall, they just need to know the direction in which the underlying asset is going.
This in turn makes binary options an investment with limited risk and reward. As the risk is limited by the amount invested in each trade. This can be beneficial for risk management purposes, as traders know their maximum potential loss upfront. However, the potential reward is also fixed, and the trader cannot profit beyond the predetermined payout, even if the price moves significantly in their favor.
Consideration
Binary options are considered a high-risk form of trading. The fixed payout structure and short-term nature can leave little room for error and cause loses to quickly accumulate if the trader is on a loss spree.