Binary options (also known as binary contracts, or digital options) are calls, puts, and range options that pay out either a fixed amount or nothing at all. The options are cash-settled and pay if the option ends up in-the-money, regardless of the amount by which the option ends up in-the-money. Binary Options can only be exercised on the expiration date. The payoff remains the same, no matter how deep in-the-money the option is. The options depend on the outcome of a "yes or no" proposition, hence the name "binary." 
Binary options were traditionally part of the over-the-counter market, but increasingly began being traded on various exchanges.
For a digital call, the option pays if the final value of the statistic is greater than or equal to the strike price. For a digital put, the option pays if the final value is less than the strike price. For a digital range option, there are two strike prices – a lower one and an upper one – and the holder of the option receives (and the seller pays) the fixed payoff amount if the final value of the statistic ends up greater than or equal to the lower strike, and less than the upper strike.
Because of the National Futures Association’s regulatory stance on the illegality of trading binary options on an OTC basis in its jurisdiction, combined with its ability to censure overseas firms which seek to provide such products to American customers, binary options can only be traded in the U.S. via regulated exchanges.
Example of A Binary Options Trade
- Crude oil futures are currently trading at $95, and you think it will end the day above $95.
- $95 becomes your strike price, and you pay $40 to buy the contract.
- Another market participant believes that it will close the day at or below $95, and puts up $60 to express his/her opinion.
- If you are correct you collect $100 and your profit is the difference between the $100 payout and the $40 you spent.
- If the opposing market participant is correct, he/she collects $100 with a profit of the difference between the $60 he/she spent to register an opinion in the market and the $100 payout.
Non-exchange Traded Binary Options and Exchange Traded Binary Options
Non-exchange traded binary options: Non-exchange traded binaries are mostly offered through brokers located in the EU. In Europe non-exchange traded, over-the-counter binary options have become very popular since 2008, when a number of online platforms started to offer a simplified version of exchange-traded options. It is estimated that there have been over 100 different platforms offering non-exchange binary options trading.
In July of 2018 binary options were banned in Europe by the European Securities and Markets Authority (Esma), because of the potential for exploitation of uninitiated traders putting their money into an activity many saw as equivalent to gambling.
Exchange traded binary options: In contrast with regular options, which have a fixed percentage payout, exchange traded binary options have a fixed payout with the price of the contract changing based on what traders are willing to pay. So if a standard $100 contract costs $40, the market believes the likelihood of that particular event to be around 40%. Unlike non-exchange binary options, the exchange does act as a counterparty, but charges traders a commission for using the exchange.
The CBOT launched electronically-traded binary options on the FOMC Target Rate contracts on July 12, 2006. Those contracts are no longer traded.
The CBOE began listing binary option contracts on the SPX and the VIX on July 1, 2008.
Regulation of Binary Options in USA
Regulated Binary Options Industry
Exchange traded binary options first came on the scene in 2007 when the Options Clearing Corporation proposed a rule change to allow them. The SEC approved cash-or-nothing binary options in 2008, allowing binary options to trade through a number of regulated exchanges, including the CBOE, AMEX and NADEX. US financial regulation prevents off-exchange option trading, therefore US citizens can only trade binary options via a regulated US exchange.
Regulated Binary Options Brokers
Traders of binary options can register and trade only at regulated and licensed binary options brokers. In order for brokers to be able to operate in these countries, they’re obliged to apply for a trading license. A license will only be awarded to completely legitimate companies that exclusively offer safe and fair services. National regulators are extremely strict about supervising the online trading market because the state also generates taxes from this practice. The state can only levy taxes from legitimate businesses.
Regulation of Binary Options - Banned in UK and Europe
The UK Financial Conduct Authority permanently banned trading in binary options starting April 2, 2019 exercising regulatory powers expanded by Mifid II to crack down on products it deemed dangerous for retail investors.
A temporary ban had been imposed in Europe by the European Securities and Markets Authority (ESMA), requiring ESMA to renew it every three months. ESMA did not renew the prohibition of binary options in July 2019, as national regulatory agencies put in permanent bans of their own in countries such as Germany, the Netherlands, Ireland, Luxembourg, Poland, Cyprus, France, Malta and Sweden.
The moves were made in tandem with European regulators' restrictions on contracts for difference.
Binary Options Fraud
The CFTC published a fraud advisory on binary options after a surge in the number of Internet-based trading platforms offering the options led to an increase in the number of complaints about fraudulent binary option promotion schemes.
The CFTC also released a video series about binary options fraud and how to avoid it, which you can find here.
Some Advantages of Binary Options
- Fixed risk and reward: Most binary options’ gains and losses are predetermined. And gains and losses are not dependent on the price of the asset during expiry.
- Capped risk: Investors will never lose more than what they put in.
- Potential opportunities of profiting from both falling and rising markets: Just as with regular options, binary trading allows an investor to absorb some of the market’s risk and make money regardless of whether prices are falling or rising.
- Access to multiple markets: From a single account, a trader can have access to a wide range of markets and asset classes including forex, shares, commodities like oil futures and stock indices.
- Easy to understand: Investors don’t need to know the direction and magnitude of the price, they only need to sense the direction of the price.
- ↑ Binary Option Definition. Investopedia.
- ↑ CBOE to list binary options on S&P 500, VIX. Reuters.
- ↑ What are Digital Options. Risk Glossary.
- ↑ Binary Options. Slope of Hope.
- ↑ Binary options trading is dead — though few will mourn it. The Financial Times.
- ↑ What are Binary Options?. The FX view.
- ↑ CBOT Binary Options on FOMC Target Rate Contracts Set New Volume Record. CME Group.
- ↑ Binary Options Regulation & Legal Situation. optionsadvice.com.
- ↑ ESMA stops renewing binary options ban. Finance Feeds.
- ↑ ESMA Issues Opinions On Product Intervention Measures By Cyprus, France, Malta And Sweden. Finance Feeds.
- ↑ BaFin to Implement Permanent Binary Options Measures. Finance Feeds.
- ↑ CFTC Fraud Advisories - Binary Option. CFTC.
- ↑ Binary Options Trading: An All or Nothing Gamble?. Finances Online.