What Are Binary Options: Definition, How Do They Work, and Example

2025.01.13 2025.01.13
What Are Binary Options: Definition, How Do They Work, and Example

Alan Tsagaraevhttps://www.litefinance.org/blog/authors/alan-tsagaraev/

The prevalence of advertisements for Forex or binary options on the Internet makes it challenging to determine which is more prominent. As a financial market analyst, I frequently come across binary options, and this is not merely a matter of contextual advertising.

Brokers often highlight that binary trading offers straightforward and rapid earnings, emphasizing that, unlike Forex, the success of this trading method hinges only on predicting the direction of price movement. This approach resembles flipping a coin, but successful outcomes are more probable when one is well-versed in market analysis. Notably, the potential for earning money on binary options is not as straightforward as it may seem, as brokerage companies rarely operate at a loss.

This article aims to provide a comprehensive understanding of binary options, including their regulatory landscape, available types, and the associated advantages and disadvantages. The material offers a more nuanced perspective on binary options, assisting you in selecting suitable financial instruments.

Major Takeaways

• A binary option is a financial derivative that allows people to predict the future direction of an asset’s price, whether it will be higher or lower than its current price once the option contract expires. If the prediction is incorrect, the investor loses the entire amount. If the prediction is correct, the investor receives a payout, the amount of which is set by the brokerage company.
• Financial regulators often view binary options negatively, sometimes even banning them amid efforts to combat financial fraud.
• Most binary options platforms are registered offshore and operate without confirming their clients’ residences, thus circumventing legal prohibitions.
• Unlike in other financial instruments, the spread is not a source of earnings for the broker in binary options. Instead, the broker profits from losing positions, creating a clear conflict of interest. As a rule, the trader always suffers losses, as the payout amount is calculated so that they remain at a loss in the long term.
• Binary options trading involves a high degree of risk, and regulatory compliance is not clearly defined in the event of disputes. The exception is the US, where this segment is under strict regulatory control.
• Strategies applied in binary trading resemble those employed in stock or Forex trading.

What Is a Binary Option?

Binary options are financial instruments in which the investor wagers on the price of the underlying asset at the end of the contract—whether it will be above or below the target price when the contract expires. Because binary options are based on a yes or no proposition and have two possible outcomes—the forecast can be correct or wrong—they are called “binary.”

Main features:

• Binary options trading is carried out through a broker. These can be exchange firms, which are popular in the US, CFD brokers (Forex), and binary options brokers offering specialized platforms.
• The underlying assets are currency pairs, stock indices, stocks, and similar instruments. The set of assets depends on the functionality offered. Notably, the assets are not physically owned. A buyer or a seller predicts the underlying asset’s price with no actual ownership involved.
• The minimum contract amount and fixed payout amount are determined by the binary options broker’s trading conditions.

If a binary option expires in the money, you can earn up to 95% of the contract amount. However, if an option expires out of the money, the loss will be 100%. In classical options, the potential profit is always less than the initial investment.

How a Binary Option Works

The main characteristics of binary options are the following:

• The expiration time is the time after which the option expires. You can specify it on the trading platform. Turbo options have an expiration time of 60 seconds. You can choose an hour, 2 hours, a day, etc.

The screenshot shows an example of setting the expiration time of 35 seconds. We can see the current market price, and the expiration date and time of the option are marked with a flag. The price that will be at that moment is called the “strike price.”

• The payout is a percentage of the premium at risk you receive based on whether the market price is above or below the strike price at expiration. The payment amount differs for each asset and can vary depending on the market situation. Brokerage companies usually specify it in advance but can change it at their discretion.

Example of a Binary Option

The following are several simple steps that unveil how to trade classic binary options:

• Analyze the market. Some brokerage companies include binary options in the popular MT4 platform, but most often, they offer their own software solutions. You can use any tools, such as technical indicators, key levels, fundamental analysis, etc.
• Choose the premium amount. As a rule, it can be $1 or more. For example, you decide to risk a $10 premium.
• Select the expiration time of the option contract. 
• Make a forecast, deciding between buying a binary put option (or “down”) or a binary call option (or “up”). For example, the current market price of Apple stock is $230. You believe that in an hour, the price will be higher. How much higher is not important. During the hour, the price can go below and above $230 many times. What matters is where the price will be in exactly one hour.
• After an hour, if the price is lower by at least one point, you lose your $10. However, if the price is higher than the target price, you receive a payout.
• If the payout rate of your binary options contract is 80%, your profit will be $8.

However, there are several nuances regarding trading conditions:

• In theory, once an option is opened, you cannot change its expiration date and the premium amount. However, it is possible to prolong the expiration date for a certain fee.
• As a bonus, a broker can offer several risk-free binary options. In case of a loss, your stake is fully or partially refunded.

There may be other choices depending on the broker.

Are Binary Options Legal?

In theory, the legality of binary options is determined by several factors, including the country of registration of a legal entity and a trader’s home country and residence. Regulatory frameworks in certain countries explicitly prohibit the operation of entities classified as binary options trading providers. Other regulators warn about high risks but do not restrict binary options trading directly or restrict it only partially. In some countries, binary options trading is legal, provided financial legislation is respected.

In practice, the regulatory landscape is more complex. Unlike Forex or the stock market, binary options trading does not entail markups (brokerage commissions) or spreads. Broker earnings remain fixed at 20% with a payout ratio of 80%, provided there is an equal number of winning and losing trades. If one trader wins and the other loses, the broker still earns 20%.

Consequently, the brokerage firm’s primary objective is to increase the number of traders who incur losses. The company is registered offshore, where the licensing requirements are more relaxed. On paper, each client must undergo verification, confirming their identity and residence. However, binary options brokers from offshore jurisdictions tend to ignore this step. In principle, anyone from any country can trade binary options. However, the US represents a notable exception from this trend.

Example 1.

You need your email address to register on a binary options trading platform. As a rule, this is the only requirement. For verification, you should confirm your email address and upload a photo of your passport or national ID card. No other documents are necessary. Your residence and citizenship are not requested for registration. You only need an email address. Notably, the verification process does not require taking a selfie with a passport. This means that anyone can use someone else’s passport to register with the broker.

Example 2.

For instance, this broker seems indifferent to the fact that I have registered as a citizen of Australia, where binary options are prohibited until 2031.

The broker does not require a confirmation of a residence address, as verification requires a passport only.

It turns out that anyone can trade binary options, and the question of legality is a moot point. These brokers have been operating in the financial markets for years, and regulators have not blocked their platforms and websites. Regulators have not accused these services of fraud, so we can conclude that they are legal. However, trading with these brokers carries a risk. In the event of any disputes, regulators may be unable to provide assistance.

Why are Binary Options Risky?

The primary risk will become apparent when you attempt to respond to the following question: Why are binary options profitable for all market participants? Specifically, it will become evident how binary options function and how the broker generates revenue. The broker’s earnings are derived from the traders’ losses. A team of analysts has long ago calculated the probability of winning trades for each asset; based on this study, the percentage of remuneration is set. If the share price is forecast to rise following a news release, the payout ratio is significantly reduced. The broker, in any case, will not remain in a loss as it can reduce the ratio at any time.

Key risks:

• Scam schemes. In the context of trading, there is a concern regarding brokers who, due to a conflict of interest, may be inclined to manipulate the market to their own advantage. Many of these brokers operate without a license and are classified as operators within the gambling sector. They establish their own browser-based platforms, which do not allow you to use verification scripts or download quotes for quality control. In addition, if a broker were to withhold withdrawals under a seemingly plausible pretext, there would be no designated channels for lodging complaints.

• The impact of further mathematics. Forecasting relies on mathematical statistics and probability theory, and brokers have access to a vast database of completed trades, ranging from hundreds of thousands to millions, across various assets. The analysts determine the optimal reward level to ensure that losses are mitigated. The question of whether a trader possesses the necessary mathematical expertise remains an open one.

• Conflict of interest. Unlike binary options, where the broker profits from the trader’s loss, Forex brokerage companies act as intermediaries, facilitating transactions to liquidity providers and ECN platforms.

• Lack of flexibility. Once a trade is opened, it cannot be adjusted, and it cannot be closed early. However, some brokers allow traders to do it for a fee.

• Spread. The broker’s earnings do not come from the spread; rather, the trader receives the premium amount + 80%, given the payout ratio is 80%. However, the spread can be manipulated. If the price is near the opening level, the spread can be adjusted to the other side of the mark at the close.

• Force Majeure. An excerpt from the user agreement: “Any technical failure shall be considered force majeure, and all trades can be canceled due to force majeure.”

Investors should be aware of the risks associated with binary options trading, including transparency issues regarding pricing, revenue generation, and trade allocation.

Risk Management

Every successful trader follows the general rules of risk management:

• Refrain from trading on the news. This is the period of greatest uncertainty when the price can exhibit significant volatility and fluctuate in either direction.
• Take volatility into account. During periods of elevated volatility, it is better to either refrain from opening a position or to reduce their volume in the market.
• Maintain emotional control. The Martingale strategy is among the most popular ways to manage emotions. It suggests you double your next trade if the previous one was losing. However, six to eight consecutive losing trades will erase your entire deposit.

Another key aspect of risk management is position sizing.

Position Sizing

You have $100 at your disposal. Would you be willing to risk $10 at once, or would you prefer to make several risk-averse trades of $1 each? This is a matter of risk management or, more precisely, your risk tolerance.

You can include the following rules in your guide to trading binary options:

• Risk per transaction: 1–3% of the deposit amount.
• Total risk for all trades: up to 15% of the deposit amount. This means you can open 15 contracts of $1 or 5 contracts of $3. If you end up losing money, stop trading and review your analysis for errors.
• The daily loss limit is 15%.
• The daily profit limit is 15–20%. The theory recommends not testing your luck. If you manage to earn 15%, stop trading to avoid excessive excitement.

You can develop your own risk management system, but the fundamental principle remains the same: strict adherence to the system is paramount.

Setting Stop-Loss and Take-Profit Levels

Binary options trading does not imply stop-loss or take-profit orders. The distance between the entry point and the market price is irrelevant. The key consideration is whether the price is above or below a certain threshold. An alternative to a stop-loss order is to set a limit for trading so you stop trading once your losses reach this predetermined limit. For instance, if you lose 15% of the deposit by the end of the trading day, it would be advisable to refrain from trading and focus on analyzing your mistakes.

Types of Binary Options

Most brokers offer classic “up/down” cash-or-nothing binary options. However, some have a wider range of options. The key difference is the need for more accurate forecasting, which can result in much higher profits, sometimes exceeding 200%. However, one should remember that all probabilities have already been calculated.

Types of Binary Options:

• Above/Below option. Also known as high/low, over/under, or up/down options, this is the most common type of binary option. It requires you to predict whether the closing price will be above or below the strike price when the contract expires.
• One-Touch option. A One-Touch option is a type where traders should predict whether the price will touch a specified level during the contract period. Once the price reaches the anticipated level, you get the profit. The subsequent price movement is not important. The payout ratio is calculated based on the proximity of the price to the set level. However, if the stock price is at $100 and the daily volatility is 2%, setting a strike price at $100.10 is impossible.
• No-Touch option. This is the opposite situation. In this scenario, it is necessary to designate a price level that will not be breached. If the price reaches this level, you will incur a loss, even if the option has not expired. As with the previous option, you cannot set a strike price at a distance of $300 from the entry point in anticipation of a modest profit, as the range in which the strike price can be set is limited.
• Range options, also known as boundary options or tunnel options, involve predicting whether the price will close inside or outside the range. For example, the current price is $100, and the range is $98–$102. The narrower the range, the higher the payout.
• Ladder options. A complex type with rewards of 500% and higher, but the risk is as high as possible. In essence, it is a broker’s Martingale. For ladder options, you predict several levels, and the payout is calculated as the price touches them. For example, if the opening price is $100 and it reaches the level of $103, the trade will bring you 25%, $105 – 50%, $110 – 100%, and so on. However, there could be a few nuances. For example, you choose only the first level, and the rest is set by the broker.

The above/below options are the simplest, while the others are much more complicated. The broker sets the reward amount in such a way that you have to decide whether to take a high-risk trade or refrain from trading at all.

How to Trade Binary Options

How do binary options work? I have tried a demo account offered by a popular binary broker, which is at the top of the Google search results page. This is in no way an advertisement or critical review; it is merely an example of how binary options work. The demo account is available without registration.

This screenshot shows the broker’s trading platform. Notably, this article was written on Saturday when the Forex market was closed. However, the broker offered to make trades on the EURUSD pair in the OTC (over-the-counter) market. How this correlates with the absence of gaps at the opening of the trading session after the weekend is a big question. By the way, such trading instruments are not uncommon.

• 1 — Select an underlying asset. This can be a currency pair, stocks, cryptocurrencies, etc. The payout ratio can be seen next to each asset. In my case, the ratio for the EURUSD pair is 88%.
• 2 — Choose a time frame. In my case, it is М15.
• 3 — The current price. It is a point at which the binary option opens.
• 4 — Type. I have chosen a turbo binary option. These options are used in short-term trading employing fast-paced trading strategies. The types can vary depending on the broker.
• 5 — Expiration time. This parameter shows the time when the option will expire. Some brokers allow you to set 1 minute, while others let you tune the expiration time with an accuracy of a few seconds. For example, 1 minute and 47 seconds. In our example, the expiration time is set to 5 minutes.
• 6 — This vertical line indicates the expiration time on the chart.
• 7 — Trade amount. Here, the premium amount is $10.
• 8 — A potential amount you can receive if your option is winning. In this case, $10 + 88% = $18.80.
• 9 — Prediction. Once all the parameters are set, select “Up” or “Down.”

If you choose the Up option and the strike price is above the opening point (point 3) after 5 minutes, you receive $18.80. Otherwise, you lose your entire wager of $10.

Binary Options Trading Strategies

Testing is key when it comes to trading strategies. It does not matter what strategy you choose; what matters is the number of successful signals, not their quality.

In the Forex market, where traders speculate on currency rate changes, one successful trade can compensate for two or three unprofitable ones because the quality of the signal makes a difference. In binary options, the outcome is known in advance – you will either lose your money or receive a payout. You do not need to analyze long-term trends; the final result is important. It will directly depend on the number of successful signals.

One of the calculation methods:

Input data:

P – the probability of a successful trade.

(1 – P) – the probability of a losing trade.

The payout ratio in case of a correct prediction is 80% or 0.8.

To gain the reward, the probability of a successful trade multiplied by the payout ratio must be greater than the probability of a loss.

Р × 0.8 > (1 – Р) × 1

1.8 × Р > 1

Р > 55.6%

The bottom line is that at least 56 out of 100 trades must be winning to keep your balance in the black, provided that the premium amount is the same for all trades and the payout ratio is 80%.

The number of successful trades can only be determined through testing, which is possible using specialized software. However, binary trading platforms do not offer such solutions. Therefore, there are two workarounds. The first involves testing your trading strategy on a demo account, which requires a minimum of 100 trades and is a time-consuming but reliable method. The second way is to open and close trades manually on the MT4 platform and calculate the percentage of successful trades through backtesting.

Now, let’s dive into trading strategies:

1. Trend strategy. The main goal is to determine the beginning of a trend and open a trade in its direction.

• Flat breakout. A flat is a period of market equilibrium. Traders await a signal to enter the market. Once the price breaches one of the boundaries of the sideways channel, a new trend starts. In a perfect scenario, the price tests and retests the channel boundary, and the trend continues. On the hourly time frame, the option expiration time should be 4-5 hours to avoid the impact of possible corrections.
• Reversal strategy. There are several signs that the trend is fading: the bodies of candlesticks shrink, and the price approaches a strong level. Once a reversal pattern appears, the price breaks through a trend line, and trend indicators – moving averages and oscillators – point to a reversal. In this case, wait for one to two candlesticks to form and open a trade that spans four to six candlesticks if a new trend unfolds.

2. Range trading. As a rule, the price fluctuates within a channel, and its boundaries can expand or narrow. The underlying principle of this strategy involves anticipating the price’s deviation from the channel’s boundaries and opening an option with a duration of 4 to 6 candlesticks, expecting it to expire in the middle of the channel.

3. News trading. This strategy involves a high level of risk due to its high volatility, the duration of which is unknown. It has proven effective in the stock market. The release of financial statements that exceed analysts’ expectations prompts a surge in stock prices within the first few hours.

As you can see, the trading strategies employed are similar to those commonly used in the Forex, stock, and derivatives markets.

How Binary Options Regulated in US

In the United States, binary options are an exclusively exchange-traded asset. They can be traded on two major exchanges: Nadex (North American Derivatives Exchange) and CBOE (Chicago Board Options Exchange). Unlicensed and offshore entities violate the laws enforced by the CFTC (Commodity Futures Trading Commission) and the SEC (Securities and Markets Commission).

And other countries?

Other countries have less tolerance for binary options. Some countries have banned them at the legislative level. Some of them classify them as gambling with appropriate legislative regulation, including the nuances of taxation of traders’ profits and requirements for brokers, which are equivalent to casinos. At the same time, some regulators just warn about the high risks that binary options may entail.

UK

In 2018, the European Financial Markets Authority (ESMA) banned retail traders from engaging in binary options trading due to the high risk of fraud. After Brexit, the UK financial regulator FCA has extended the ban.

Canada

In Canada, regulators increased their oversight of the binary options segment in the middle of the last decade. However, Canada is comprised of provinces, each with its own legal and regulatory landscape.

In 2017, the country’s primary regulatory authority, the CSA, imposed a comprehensive ban on binary advertising and trading. The rationale pertains to Canada’s position as a global leader in combating financial market fraud. However, Canadians retain the option to utilize offshore alternative platforms.

Australia

The Australian Securities and Investments Commission (ASIC) is a highly regarded financial regulatory body, ranking among the top in the world, along with the United States Securities and Exchange Commission (SEC) and the United Kingdom’s Financial Conduct Authority (FCA). Representatives of ASIC have been conducting extensive research on the binary options market for over five years. Over a 13-month period ending on May 3, 2021, the regulator compiled the following statistics:

• 70–74% of active buyers and sellers lost money on binary options. The total amount is not specified.
• Net losses of retail buyers and sellers amounted to about $14 million.
• The total losses on unprofitable accounts amounted to about $15.7 million, and the total profit of those who managed to earn on binary options was $1.7 million.

In order to safeguard potential customers seeking what they consider to be “lucrative” opportunities, the ASIC has banned the provision of binary options trading services to retail customers, effective until October 1, 2031.

New Zealand

New Zealand has adopted a different regulatory approach than Australia. In 2017, it introduced a mandatory licensing regime for brokers. This regime requires all binary brokers and CFD brokers offering instruments with an expiry date of up to three days to obtain a license from the Financial Markets Authority (FMA). This requirement applies to any broker advertising binary options products in New Zealand, regardless of registration status.

Advantages and Disadvantages of Binary Option Contracts

Experts generally outline numerous advantages of binary options, making them a suitable choice for beginners due to their simplicity compared to other trading instruments. However, there are also several disadvantages that significantly outweigh the benefits, primarily the lack of regulation and a high frequency of fraudulent activity.

Binary Options vs. Vanilla Options

Binary and exchange-traded options, or “vanilla options,” are two different financial instruments. Binary options refer to a wager on the rise or fall of the price of an asset. Vanilla options are financial derivatives based on a real asset, giving the owner the right to buy or sell the underlying asset at a fixed price after a certain time. These options are used to hedge risks.

Binary Options vs. Classic Margin Trading with LiteFinance

These two instruments are often compared because of their similar nature. In both cases, a trader does not own the actual asset but only predicts the future direction of its price.

Binary Options vs. Forecasts for Quotes from LiteFinance

Forecasts for Quotes is a similar instrument, but there is a significant difference. It complies with financial legislation and does not violate regulatory requirements.

Let’s look at a few facts about LiteFinance’s Forecasts for Quotes:

• This instrument allows you to generate profits by predicting the future price direction. In contrast to OTC binary options brokers, LiteFinance boasts a proven reputation and robust internal regulations, and market quotes ensure full compliance with legal standards.
• There is no need to calculate position volume in lots or set stop-loss and take-profit orders.
• The contract has no expiration date; it remains open as long as the price remains within the selected range.

How it works:

• Choose an asset. You can select from over 300 assets, including currency pairs, stocks, stock indices, commodities, and cryptocurrencies.
• Specify the contract amount. The minimum amount is $10. Unlike CFD trading, you do not need to calculate the position volume in lots, convert it into currency, etc. You just specify a fixed contract amount in US dollars.
• Indicate a projected rate change in points. For instance, if you set a target of +20 points above the current price.
• Once the price reaches that level, you will earn a profit. Conversely, if the price goes in the opposite direction by 20 points, you will incur a loss. Notably, you can close the contract prematurely. Meanwhile, a commission of 10% is applied to each contract, regardless of the outcome.

Below is a comparison table of binary options and LiteFinance’s Forecasts for Quotes.

Are Binary Options Good for Beginners?

In the context of training on a demo account, this instrument can offer several key advantages for novice traders:

• Simplicity. Binary options are straightforward, eliminating the risk of losing the entire deposit if the price deviates from a trader’s prediction. The potential earnings or losses are known in advance, providing a clear understanding of financial outcomes.
• Minimal number of tools. A trader does not have to calculate the cost of a point, as well as set stop-loss and take-profit orders.
• Low risk. Binary options ensure a low-risk learning environment. The minimum bet is $1. On Forex, the minimum position volume is 0.01 lots.

Binary options provide a much easier approach to trading, making them less complex than CFDs or stocks. Notably, this is their only advantage. As the aforementioned examples demonstrate, the majority of brokerage firms are offshore platforms that prioritize profit generation over customer satisfaction. Although governments attempt to supervise these brokers, these efforts have not succeeded.

In contrast, Forex pairs and stock trading do not involve conflicts of interest, as the broker’s revenue is derived from markups or commissions, regardless of the client’s trading outcome. As a result, the broker’s best interest is to provide maximum transparency and gain the client’s trust, which is why stock and CFD brokers have stringent verification requirements, including proof of residence and selfies with a passport or an ID card.

In this regard, beginners may want to hone their analysis skills on binary options demo accounts, learn to use technical indicators, and master the principles of market analysis. After that, they can move on to demo accounts and try their hand at CFD trading, which will seem less complicated after binary options trading. Finally, they can proceed to live trading on the Forex market or a stock exchange.

Conclusion

Binary options are a financial instrument that involves predicting whether the price will be higher or lower at the end of its expiration time determined by a trader.

The key challenges within this segment are fraud risk and conflicts of interest between trading services providers and their clients. According to the statistics provided by regulatory authorities, the level of fraud in this sector is extremely high. Therefore, binary options are prohibited or classified as gambling/casinos in various regions. Notably, the US is an exception, where this segment is subject to stringent regulatory oversight.

The most prevalent type of binary option is “up/down,” though they also have the lowest payout ratio. The ratio is determined by overall trading performance.

The principles of trading are relatively straightforward, making it a suitable practice environment for honing skills on a demo account. Trading strategies are similar to those employed for trading other instruments. For example, trend trading, pivot points, and trading on news, etc.

The inherent risk of binary options offered by offshore brokers is the potential for financial loss. A viable alternative for novice traders is to place contracts for quotes with a reliable broker that has a license to provide such services and has no conflicts of interest. To explore this option, register and test the new trading instrument on a LiteFinance demo account.