Let’s review some key facts to remember when trading binary options:Fact 1: If the market price is above the strike price at expiration, the contract value goes to $100. If the market price is below the strike price at expiration, the contract value goes to $0.Fact 2: You can always trade in and out of a binary option contract any time before expiration and settlement.Fact 3: The collateral you put up for a binary option trade is always equivalent to your maximum loss on the trade.Fact 4: Binary options have no calls or puts.
They simply have conditions (also known as strike prices) that you can speculate on to be true or not. If you believe a condition to be true by expiration, you buy the binary option; if you would like to speculate for it to be false, you sell the binary option on that condition.Fact 5: You can never lose more than you put into a binary options trade. You put up your maximum loss as the collateral and can never lose more than you put up on your trade.
Fact 6: The most collateral any contract will require you to put up on a trade is $100; typically, the collateral you put up will be less than $100 on any binary option contract.Fact 7: When trading a binary option, if you are correct on your trade at expiration, your account will always be credited $100 per contract. If you are incorrect at expiration, your account will always receive nothing.
Taking these facts into consideration, let’s look at some simple trade examples to solidify the concepts.Buy: At‐the‐Money Example:Let’s review the following at-the-money trade example:Rationale Gold futures are currently trading at 1700.5. You assume that gold futures will be above 1700.5 at expiration.Entry Breakdown You buy one contract of gold binary options with a strike price of 1700.5 and an ask price of $62.5 per contract.
The required collateral to place this trade is $62.5, which is your maximum potential loss on the trade. Exit Breakdown If the market closes above 1700.5 at expiration, the contract will be worth $100 and you will make a profit of $37.5 per contract or 60 percent on your trade.However, if the market closes below 1700.5, the option will expire worthless and you will lose $62.5 per contract.Sell: Out‐of‐the‐Money Example:
Let’s review the following out‐of-the-money trade example:Rationale Gold futures are currently trading at 1690. You assume that gold futures will go down and close below 1680 at expiration.Entry Breakdown You sell three contracts of gold binary options with a strike price of 1680.5 and a bid price of $83 per contract. In order to get into the position, you will need to put up $17 in collateral per contract (this is the difference between the option premium and $100), for a total of $51.
Exit Breakdown If gold futures go below 1680, you will win on your trade and your account will be credited $100 per contract. If you subtract the $17 per contract collateral from this revenue, your profit will be the option’s premium, $83 per contract, for a total of $249. However, if the market stays above $1680, you will lose the $17 per contract collateral for a total loss of $51.Exhibit 7.4 depicts the P&L of going short the 1680 gold binary option.
The x‐axis represents the price of the underlying, and the y‐axis represents profit and loss.Buy: In‐the‐Money Example:Let’s review the following in‐the‐money trade example:Rationale Copper futures are currently trading at 384.5. You forecast that copper futures will stay above 379.5 at expiration.Entry Breakdown You buy five contracts of copper binary options with a strike price of 379.5 and an ask price of $78 per contract.
The required collateral to place this trade is the premium of $390 ($78 × 5), which is also your maximum loss.Exit Breakdown If copper futures close above 379.5 at expiration, each contract will be worth $100 and you will make a profit of $22 per contract or 28 percent on your trade. On a five‐contract position, you will make a profit of $110 on this trade.However, if copper futures close below 379.5, the option will expire worthless.
The collateral you put up here is $78 per contract, which is the price of the option. On a five‐contract position your loss is $390, the collateral.Exhibit 7.7 depicts the P&L of going long the 379.5 copper binary option.The x‐axis represents the price of the underlying, and the y‐axis represents P&L.