Binary Options Terminology Explained

For those who wish to learn option trading, and how to trade binary options in particular, one of the first steps to take is to gain a thorough understanding of the highly customized terminology commonly used to refer to these various aspects of these derivatives.

To assist in this endeavor, the following list consists of frequently used words and phrases related to trading binary options that might make up part of a binary option trading guide.

Nevertheless, it is worth noting that the terms used to refer to characteristics of binary options can vary somewhat between different binary option brokerage firms, so be sure to clarify exactly what these terms mean at the binary options broker you intend to use.

Asset: Also sometimes known as the underlying, this term refers to a commodity, stock, index or currency pair upon which the binary options are based.

At the Money (ATM): The situation where the binary option’s strike price is the same as the current price of the underlying.

Binary Option: An option that pays out a fixed amount if in the money in return for a known premium that is paid up front.

Call Option: Sometimes called an “above” option, it gives the purchaser a fixed payout if the underlying market is higher than the binary option’s strike price.

Current Price: Refers to the presently prevailing value of the underlying asset that binary options are based on.

Digital Option: Another term used to refer to binary options, and especially to those binary options that have fixed odds.

Expiration: The date and time that binary options mature and when these options are determined to be in, out of, or at the money based on the value of the underlying.

In the Money (ITM): The situation where the binary option’s strike price is more favorable than the current price of the underlying.

Out of the Money (OTM): The situation where the binary option’s strike price is less favorable than the current price of the underlying.

Payout: The amount that binary options generate for the purchaser if they expire in-the- money.

Premium: The up front cost involved in purchasing binary options.

Put Option: Sometimes called a “below” option, it gives the purchaser a fixed payout if the underlying market is under the binary option’s strike price.

Straddle: A binary option trading strategy that involves purchasing both a binary put option and a binary call option with the same strike price.

Strangle: A binary option trading strategy that involves purchasing both a binary put option and a binary call option with different strike prices, usually with both strike prices set initially out of the money by a similar amount.

Strike Price: The asset price characteristic of binary options that the underlying market must exceed — in the case of a call option — or be below — in the case of a put option — in order for the binary option to generate a payout.

Underlying: This term, also sometimes called the asset or underlying asset, refers to the commodity, stock, index or currency pair that the binary options are based on.

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Binary Options Can Help Avoid Order Problems in Volatile Markets

The limited risk nature of trading binary options helps make purchasing them an especially interesting option trading strategy over very volatile trading periods.

Basically, using a long binary option trading strategy allows a trader to remain involved in a fast market without being subject to especially frustrating trading problems like substantial stop loss order slippage and briefly triggered stop loss orders after which the market subsequently reverses.

Using a binary option trading strategy in such a situation usually involves purchasing binary options that expire soon after the volatile period has concluded. Employing this sort of strategy can help a stock, commodity or forex trader manage such potentially problematic markets in a way that limits their risk to the premium paid for the binary option.

Non Farm Payrolls Binary Option Trading Strategy Example

For example, when a major economic number like U.S. Non-Farm Payrolls comes out, the forex market can go haywire for a short period of time while the news is discounted into the various major exchange rates.

These sharp price swings can result in frustrating forex trading challenges like barely triggered stop loss orders from which the market promptly recovers. Such volatility can also result in substantial slippage on stop loss orders that can be a painful surprise to a trader expecting to be filled at their order level.

A savvy trader might use a forex option trading strategy that involves purchasing a binary option straddle. This is a two legged option trading strategy in which both a binary call option and a binary put option with the same strike price are purchased on the underlying exchange rate.

Thus, if the Non-Farm Payrolls result comes out substantially different from the market consensus and the forex market reacts strongly, the trader will likely be able to profit on the leg of the binary options strategy that has gone in the money.

Furthermore, if the volatile market then reverses and returns to previous levels, as is sometimes the case, then the trader may be able to benefit from profits on the other leg of the binary option trading strategy.

Beware of Higher Premiums and Lower Payouts

It is perhaps worth mentioning that some online binary option broker websites are probably wary of writing binary options over such volatile trading periods due to the greater risk involved.

As a result, they may reduce payouts on binary options accordingly, and they might also mark up the premium cost of purchasing such riskier binary options. This effect can be even more notable with especially short term binary options with tenors that include a major risk event that is widely expected to create volatility in the underlying market.

Nevertheless, traders who have access to a decent binary option brokerage service that offers competitive pricing can usually still take advantage of the useful limited risk characteristic of binary options to help them manage risk appropriately while still being able to participate in especially fast markets.

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Benefits of Trading Binary Options

Binary options have gained an increasing share of the derivative market for those engaged in active forex, stock and commodity option trading in recent years.

In addition to providing a potentially valuable form of diversification and risk management to a trading portfolio, some of the significant benefits unique to trading binary options are detailed further in the sections below.

Binary Options are Relatively Easy to Understand and Use

Those who wish to learn option trading techniques can benefit from starting with binary options due to the simplicity of their payout structure.

In essence, the premium paid for binary options will be the maximum loss the trader will incur on their positions, while the maximum benefit will be the binary option’s payout if the binary option expires in the money.

Take Limited Risk to Potentially Earn Limited Rewards

One of the primary advantages of purchasing binary options — as with just about any long option trading strategy — is that the trader will know the full extent of the risk they are taking in advance.

Another significant benefit is that they also know in advance how much reward they will earn if their option trading strategy turns out to be correct. This combination of binary option characteristics allows a forex or commodity trader to compute their risk/reward ratio on the transaction very easily.

Furthermore, to a trader, this unique limited risk and payout characteristic of binary options makes the risk of purchasing them a bit like having a guaranteed stop loss order in place that is only triggered if the option is out of the money at its expiration.

When considering the profit side, long binary options somewhat resemble placing a take profit order that can only be executed at the options’ expiration.

Shorter Trading Time Frames

Binary options may be more suitable for active traders due to the common availability of expiration time frames that are relatively short in duration.

While traditional options may take months or even years to expire, a binary option trading strategy can be implemented with a much shorter time period until expiration.

Depending on the specific binary option broker involved, common tenors for commodity and forex binary options can vary from a week to a day. Some option brokerage firms even offer binary option expirations occurring less an hour from the time the option contract is executed.

Accessibility to Smaller Traders

Another advantage of using binary options as part of a commodity, forex or options trading strategy is that they can now be purchased in relatively small minimum dealing amounts from option brokerage firms that cater to retail traders.

This small dealing amount or lot size can also be readily scaled up by more adventurous traders to increase the risk taken on a particular position or option trading strategy.

Trading Volatile Markets Using Binary Options

To a forex or futures trader, the guaranteed limited risk and payout characteristic of binary options can make their returns superior to placing traditional orders in so-called volatile or fast markets that often occur during key announcements and news events.

In essence, a set of stop loss and take profit orders entered in the market to be executed can sometimes suffer from slippage or being missed in volatile trading conditions.

Binary options have gained an increasing share of the derivative market for those engaged in active forex, stock and Commodity option trading in recent years.