Many of you may still wonder, how exactly a binary options trade works. Here I will assuming that you already have apprised yourself with the basic concepts of derivative trading, such as bid/ask price, call or put option, the difference between exotic options and vanilla options, terms such as payoff, in the money, out of money, etc. A detailed example of such a trade can help clear things for you.
Setting the Stage:
A binary option is based on the anticipation that the price will move either up or down for a given asset. This anticipation is fed by the analysis that may be technical or fundamental, what a derivatives trader normally does. If a trader believes that the strike price for GBP/USD will close at or above 1.55, he will normally buy a call option. If another trader believes that, the strike price will close at or below 1.55, he will normally buy a put option.
Binary Option in Action:
Let us assume that the trader believes the strike price will close at or above 1.55 by 3:00 PM. He takes this decision at 2:00 PM when price is 1.51. When trading in binary options, the trader will simply buy a few call options; say 5 call options contracts of minimum lot for a price of $5 each. This makes up his cost, that is, $25. The broker offers a successful bet with a fixed payoff, say $20 for each options contract.
Following the ‘all or nothing’ approach of the binary options, the trader can lose all the money he has invested, which is $25 in our example, if the price stays below 1.55. Or he can make a gross profit of $20 X 5 = $100, if the price stays above 1.55 at 3:00 PM. Therefore the trader’s net profit will be $100 – $25 = $75. It should be noted here, that the trader already knows the risk he faces at the time of trade.
The trader can also liquidate or close his position (by selling or buying a contract) before reaching the expiry time. In such a case where the spot price is below the strike price, the larger there is a difference, the larger will be the loss. This is because the value of the option decreases, the further a spot price moves from contract’s strike price. Visit http://www.intellitraders.com/binary-options to know more about how binary options works.