Traditional options and binary options are two very different types of financial instruments, and in many ways the term binary options may be somewhat confusing. Binary options are, however, built on top of traditional options, but their exotic nature removes many aspects of the traditional option to simplify the transaction for the user.
Both traditional options and binary options are derivatives – this means that their value is derived from the value of some other asset. Traditional options, however, confer the actual option to either buy or sell that asset at its strike price.
Most of the traditional options are actually traded on an official market, and everything is settled through a clearing house, with standardized contracts. While there are a handful of exchange traded binary options, generally when people refer to binary options they are talking about an over-the-counter (OTC) form of binary options, traded between two private parties.
Binary options do not include the option to purchase or sell the asset itself. The asset is used in a binary option only as a benchmark for the option itself to determine whether the contract has expired in-the-money or out-of-the-money. The underlying asset exists solely as a proxy, and in fact virtually anything could be used as an underlying asset, although most binary options utilize traditional assets that one might also see in a traditional option contract.
Purchasing a binary option entails simply finding an underlying asset with a contract available, determining whether the value will increase or decrease before the contract expires, and purchasing either a Call or Put option respectively. If at the contract expiry the investor was correct in their prediction, they have finished in-the-money, and receive a fixed payout. If they were incorrect, they have finished out-of-the-money, and suffer a fixed loss. This is incredibly different from a traditional option, in which an investor might purchase an option, and then watch the underlying asset day to day to see how far it shifts, to decide whether they want to exercise their option to either buy or sell the asset.
The information in this analysis is collected from different sources and should serve for informative purposes only. The author shall not be held responsible for the validity of the presented information. No part of this analysis recommends the purchase or sale of a currency pair or any other financial instrument.