A binary is simply a different way to count, using just two numbers. Zero and one. All computer logic is built on the foundation of binary numbers, the simple ‘yes/no’ switch of a zero or a one, from which complex operating systems are constructed. The term binary has been adopted in the trading world in this context, to describe a trading instrument which only has two possible outcomes.In other words, ‘the event’, will either occur or not.
For example, I might ask you if you think it will rain tomorrow? If you think it is going to rain, you answer yes, but if not the answer is no.Either it rains or it doesn’t. In probability theory (of which much more later), these are referred to as ‘mutually exclusive’ events, because it is impossible for them to happen together. Another example would be a head or a tail when tossing a coin. Only one outcome is possible, either a head or tail.
And now the word binary itself is increasingly being replaced with the word digital, just to add to the confusion.At this point you could conclude a bet is a type of binary, and I would have to agree. That’s exactly what it is, and herein lies all the confusion. In many ways the word binary is irrelevant because you could use words such as ‘button’, ‘switch’, ‘polar’, almost anything which has a yes/no, or an ‘on or off’ connotation.
The industry just happens to have chosen the word binary, but the meaning of the word from a trading perspective is meaningless.The second word is option which is where the whole field of binary trading becomes very grey. Vanilla options have been available as trading and investing instruments for many years, but are a very different instrument.
And whilst there are common principles which apply to both, which I will explain in detail later, the risk profiles of these instruments are very different. Just to recap on the terms exotic and vanilla options. This is all this means. An exotic option loosely refers to a binary option, whilst a vanilla option refers to those quoted on a central exchange such as the CME (Chicago Mercantile Exchange).
For our purposes here, and for the time being, just think of the word option in the context of the binary option, as whether you are agreeing or disagreeing with the proposition of an event happening or not.In summary. A binary option (or a digital option if you prefer), is an option to purchase to agree, or purchase to disagree, with an event which can only have two outcomes. It either happens, or it doesn’t.
But, here is the key point. The event has to happen or not happen within a pre determined period of time. Time is one of the principle governing factors and an immensely powerful force, not just in the world of binary options, but in all options markets. But again I am going to cover this in detail shortly, but first things first.Let’s take a simple example of a binary option, which could be as follows:
Will the price of gold be above $1,225.30 per ounce in the next 15 minutes, or below? You will be presented with two possibilities, something along these lines:Will the price of gold be above $1,225.30 per ounce in the next 15 minutes? Will the price of gold be below $1,225.30 per ounce in the next 15 minutes?Alongside will be quoted some odds for the event, and an explanation that success or failure will be measured against the underlying spot gold price.
If you think the answer is yes, the price of gold will be above $1,225.30 per ounce in the next fifteen minutes you purchase the first proposition, but if you think the answer is no, you purchase the second proposition. All you do is then wait 15 minutes. If you are correct you win, but if not you lose. Does this sound simple? Yes, because in principle it is. This is the simplest type of binary option, and often referred to as the ‘up/down’ bet.
There are many other types, which again I will explain as we move forward, but the underlying principle is the same. You are essentially being asked to decide whether an event, in this case the price of gold, is likely to happen or not, and all that is required is a simple yes or no answer. This is what I referred to as the simplicity of the instrument in my introduction.The questions that follow are whether this is betting, trading, or investing?
After all I could argue all we are ever attempting to do, whether as speculators or investors, is to answer this very question. Is the market going up or down? Or perhaps more accurately, up, down or sideways, a choice which is also catered for in the binary options world. However, what we are also attempting to forecast here is not simply whether the event will happen or not, but also whether it will happen within a predetermined period of time.