Unlike regular options, binary options offer fixed payout, with profits and losses calculated in advance. However, different equity markets can offer different conditions for binary options on same financial instruments: commodities, events, currencies etc. Let’s try to explain how binary options work in equity markets.
Call and put binary options
Binary options offer fixed payout if the specified conditions are met upon expiration. Call options pay out if the strike price is below the market price at the moment the binary option expires, while put options offer payout if the strike price is above the market price at the moment the binary option expires. Otherwise, the options expire worthless and you lose your premium. But what if the strike price and the market price are identical and the binary options expire as such? Well, that depends on the equity market and its conditions. Some equity markets actually pay out holders of such binary options in full, while others rule out that requirements have not been met and holders get nothing. This is why it is always a good idea to familiarize yourself with the equity markets you do business in, as well as their rules and regulations.
Pricing of Equity Markets Options
These regulations also govern the manner in which binary options are priced. If the likelihood of an outcome is estimated at 80%, the price of the contract would be 80 dollars per option; likewise, the opposite outcome would have 20% chance of success, and the price tag would be 20 dollars. That contract would be priced 20/80. If an option is priced 20/80 dollars, the actual price is either 20 or 80 dollars per contract, depending on the outcome – your counterparty will supply the rest. If you got the 80 dollar contract and won, your net gain would be 20 dollars (25% of your investment). Or, if you got the less likely 20 dollar contract and won, your return would be a staggering 400%. In the meantime, the price of said options may change to, say, 30/70 and you might be able to let your options go at current price – earning 50% if you bought the cheaper option or salvaging 87.5% of the more expensive one.
The current price of gold is 1139.95 dollars per ounce. You feel bullish about gold and expect an increase in price, at least 1142.80 within 5 days. You find the appropriate call option, valued at 55 dollars and buy 100 contracts for 5500 dollars. Your counterparty agreed to supply the rest.
In case you chose to follow through, there are three possible outcomes: a) Five days later, the price of gold is 1143.95 upon expiry and you get 10000 dollars, roughly 82% return, b) The price of gold is 1142.80, in which case it comes down to the market rules or c) The price is 1140.57, meaning you lost 100% of your investment. Or there is the (secret) d) outcome: you manage to cash out early at market prices.