What Is a Binary Option?

A binary option is a financial product where the parties involved in the transaction are assigned one of two outcomes based on whether the option expires in the money. Binary options depend on the outcome of a "yes or no" proposition, hence the name "binary." Traders receive a payout if the binary option expires in the money and incur a loss if it passes out of the money.

How a Binary Option Works

Binary options have an expiry date and time. At the time of expiry, the underlying asset's price must be on the right side of the strike price (based on the trade taken) for the trader to profit.

A binary option automatically exercises, meaning the gain or loss on the trade is automatically credited or debited to the trader's account when the option expires. That means the buyer of a binary option will either receive a payout or lose their entire investment in the trade—there is nothing in between. Conversely, the seller of the vote will either retain the buyer's premium or be required to make the total payout.

How To Make Money Trading Binary Options

Now that we have a basic idea of how binary option trades work, let’s look at a simple example.

Let’s say you decide to trade EUR/USD with the assumption that the price will rise.

The pair’s current price is 1.3000, and you believe that EUR/USD will be higher than that level after one hour.

You then look at your trading platform and see that the broker’s payout is 79% on a one-hour option contract with a target strike of 1.3000.

After much deliberation, you finally decide to buy a “call” (or “up”) option and risk a $100.00 premium.

You could say it’s similar to going “long” on EUR/USD on the spot forex market.

Expiry price is above the strike price
$100.00 x 79% = $79
$100.00 + $79.00 = $179.00
You gain $179.00 on your account.
Expiry price is equal to or below the strike price
You lose your stake and your account declines by $100.00.

As you can see from the calculations above, the risk you take is limited to the premium paid on the option.

You cannot lose more than your stake. Unlike in spot forex trading, where your losses can get bigger the further the trade goes against you (which is why stopping stops is crucial), the minimal risk in binary options trading.

Payouts in Binary Options

Now that we’ve looked at the mechanics of a straightforward binary trade, we think it’s high time for you to learn how payouts are calculated.

More often than not, the payout will be determined by the size of your capital at risk per trade, whether you’re in- or out-of-the-money when the work is closed, the type of options trade, and your broker’s commission rate.

In the example given above, you bet $100 that EUR/USD will close above 1.3000 after an hour with your broker offering a 79% payout rate. Let’s say that your analysis was spot on, and your trade ends up being in-the-money (ITM). You would then get a payout of $179.

$100 (your initial investment) + $79 (79% of your initial capital) = $179

Easy peasy, right? Don’t get too excited just yet! You should know that there’s no one-size-fits-all formula for calculating payouts. There are a few other factors that affect them.

Factors in Payout Calculations

Each broker has its payout rate. For starters, Forex Ninja’s intel shows that most brokers offer somewhere between 70% and 75% for the most basic option plays, while some offer as low as 65%.

Various factors come into play when determining the percentage payout.

The underlying asset traded and the time to expiration is a couple of significant components to the equation.

Usually, a relatively less volatile market and an expiration time that is longer typically mean a lower percentage payout.

Next, the broker’s “commission” is also factored into the payout rate. After all, brokers provide a service for you, the trader, to play out your ideas in the market, so they should be compensated for it.

The commission rate does vary widely among brokers. Still, since there are so many binary options brokers out there (and more coming along), the rates should become increasingly competitive over time.

When a Binary Options Trade is Closed

As mentioned before, binary options are typically “all-or-nothing” trading instruments in that the payout or loss is only given at contract expiration. Still, there are a few brokers that allow you to close binary options trade ahead of end.

This usually depends on the type of option. Usually, it’s only available within a specific timeframe (e.g., available 5 minutes after an option trade opens, up until 5 minutes before an option expiration).

The trade-off for this flexible feature is that brokers who allow early trade closure tend to have lower payout rates.

When trading with a binary options provider that allows early closure of an options trade, the option's value tends to move along with the underlying asset's value.

For example, with a “put” (or “down”) option play, the value of the option contract increases as the market moves below the target (strike) price.

This means that depending on how far it has moved past the strike, the closing value of the option may be more than the risk premium paid (but never more significant than the agreed maximum payout).

Conversely, suppose the underlying market moved higher, further out-of-the-money. In that case, the option contract's value decreases, and the option buyer would be returned much less than the premium paid if they closed early.

Of course, the broker commission is factored into the payout of an options trade when closed early in both cases.

So before you decide to jump headfirst into trading binary options, make sure you do your research and find out what your broker’s payout rates and conditions are!

3 Types of Binary Options

The main factor when talking about payouts is the type of binary option traded.

The option trade example given in the previous section is an “up/down” option and is considered the most straightforward kind.

Predicting if a currency pair would be above or below the strike price before it expires pays the lowest return.

This averages between 70%-90%, depending on your broker.

Meanwhile, more complicated options like the “touch and range” binary options have higher payouts since winning such trades tends to be more challenging.

From what we’ve gathered, brokers usually offer payouts around 200%-400%, and a few can even go as high as 750%!

Up/Down Options

An Up/Down option can go by a few different names: High/Low, Above/Below, and Over/Under. It is the simplest and most common type of binary option.

Traders purchase a “call” option if they believe that the closing price will be above the strike price when the contract expires, or buy a “put” option if they think that market will close below the strike price at expiration.

The EUR/USD trade example given in the previous section illustrates how an Up/Down option typically works.

Easy enough, eh? The simplicity of this option is why Up/Down options usually have the lowest payouts.

Up/Down options typically expire within an hour or a day, but some brokers offer options that expire in minutes. Heck, some even expire in seconds!

Of course, this could either do your account a lot of good, or it can cause a whole lot of damage. Make sure you manage your risk correctly!

Touch Options

One-Touch option trades don’t require the market to be above or below a certain level at expiration. Instead, it just needs to TOUCH the strike price at least once during the option contract period to be profitable.

On the other hand, No-Touch trades require that the market price DOES NOT TOUCH the strike price during the contract's life for a trader to make profits.

Touch trades are offered during certain times of the day, and some brokers offer touch trades during weekends that usually offer higher payouts (around 250%-400% of your risk premium) than a simple Up/Down option trade.

For example, let’s say that EUR/USD closed at 1.3100 on Friday.

Over the weekend, your broker offers a call option where you will profit if EUR/USD touches 1.3450 at least once next week and a put option where you will benefit if the pair touches 1.2750 at least once in the same period.

You decide to take the call option. During the option period, you find that EUR/USD had reached a high of 1.3600 before closing at 1.3050.

Since the market reached the call option’s strike price (1.3450) within the option period, you would have won the trade even if it didn’t close above the level.

On the contrary, those who took a No-Touch option on the same price would have lost their trades since the pair DID touch the strike price.

Touch trades typically work out well when volatility picks up, while no-touch transactions are ideal for pairs that tend to consolidate.

Still not exciting enough for you?

You can also try out Double Touch/Double No-Touch options!

They are just like Touch/No-Touch options, only with two strike prices. The asset’s price has to touch (or not touch) two different levels for a trader to win the trade.

Range Options

Trading Range/Boundary/Tunnel options is like playing the Super Mario underwater level wherein Mario cannot touch both the top and the bottom of the screen.

For In Range trades, the market price must stay within a predetermined range and avoid touching the two strike prices within the option period for your business to be in the money.

Some brokers offer Out of Range options where traders can profit if the price breaks out of the predetermined range within the option period.

For example, EUR/USD is currently trading at 1.3300, and the ECB interest rate is minutes away.

Your broker is offering a range option between 1.3280 and 1.3320 that expires in one hour. You that the ECB’s decision is a non-event, so you bought an “in-range” option.

If the price doesn’t reach 1.3280 or 1.3320 within the option period, then you would have won your trade.

That should be excellent news for you because range options usually have the highest payouts, with a few brokers offering between 200%-750%!

Range options are best used when volatility is low, although some brokers offer the opportunity to take a risk on the idea that price WILL break out of the predetermined range.

Alternatively, a few brokers also offer options on predetermined ranges far from the current market price.

Market Analysis For Binary Options

Remember back when you enrolled yourself into the School of Pipsology? We talked about “The Big Three” types of market analysis. In case you forgot, they are:

  1. Fundamental Analysis
  2. Technical Analysis
  3. Sentiment Analysis

Why are we bringing this up again? The good news is that these building blocks of analysis can also be used when trading binary options!

Fundamental Analysis

Trading the News

One way to make use of fundamental analysis would be to go with a trade-the-news strategy.

If you’ve gone through our lesson on this trading strategy, you would know that this is best applied to those events that usually cause a ton of volatility. The spike in volatility tends to lead to fast moves, which can send prices rocketing higher or plunge lower.

For binary options, this can be particularly effective when you trade simple Up/Down options.

After all, you need to understand how price may react to better/worse than expected data and how strong the reaction may be. You have to be confident that the price can reach the strike price of the option you bought.

For example, you plan to trade the Australian retail sales report. Let’s say you have a bullish bias on the results.

The chances are that a better-than-expected result will spur the Aussie to new highs, so you would look to buy a “call” option on AUD/USD.

Now let’s say that, as you expected, we saw a better-than-expected result. Luckily, AUD/USD also rose, rising above the strike price. Paycheck time, baby!

Of course, there are a couple of factors to take into consideration when playing the news.

First is the potential for volatility. When playing a news report and buying a binary option, you must be pretty confident that the event will spark enough volatility to reach the strike price and stay above/below that level.

If you try trading a report that rarely causes a ripple, you’ll be throwing money down the drain.

Second, you have to factor in the time component of binary options.

Remember, for the simple Up/Down options, the price has to be above or below the strike price at the expiration date.

When trading binary options and implementing a trade-the-news strategy, you may also want to consider going with one-touch options since the price would only have to touch and not necessarily close at a particular level.

You can also try the Out of Range options if you expect the price to move with strong momentum away from its previous range.

With this option, you don’t have to pick a direction; decide whether or not the market will move big time in one direction or another.