In order to define and explain a binary option and its function in the financial markets, it is important to define what a financial “option” is first.
An option is basically a contract between a buyer and a seller in which the buyer obtains the right but not the obligation to purchase a financial asset at a specific price during a predetermined time frame. The seller, on the other hand, accepts the obligation to fulfill the transaction specified in the option if the buyer chooses to exercise the option. The option’s value is based upon the value of the financial asset that it is derived from which can be a share of stock, a bond, a currency or a futures contract among other things.
Simply put, if Trader A purchases a call option from Trader B for a barrel of oil at $75, it means that Trader A nows has the right to purchase a barrel of oil at $75 from Trader B should he choose to, in other words, he is under no obligation to purchase the barrel.
Using the example above, Trader B could also choose to purchase a put option from Trader A for $75 which would mean that Trader A would be obligated to purchase a barrel of Trader B’s oil at $75 should Trader B decide to exercise his option.
The keys terms to know for options transactions are:
Underlying asset: The financial asset that an option contract is based on and that will be sold or purchased depending on the option’s terms. In the examples above, it was one barrel of oil.
Strike price/Exercise price: The price at which the transaction stipulated in the option will occur. In the examples above it was $75.
Call option: An option that bestows the right to buy the underlying asset.
Put option: An option that grants the right to sell the underlying asset.
In addition to these terms, it’s important to understand that there are various types of options that have different rules regarding how and when they may be exercised: American and European options are the two most common types of options.
Here are examples and scenarios of how American and European options function and what purpose they serve in the global financial markets.
X purchases an option for a barrel of oil from Y on November 1st in which X obtains the right but not the obligation to buy a barrel of oil for $100 on or before December 1st. On November 17th, the price of a barrel of oil rises to $125 so X chooses to exercise his option and Y must sell X a barrel of oil for $100. X thereby saves himself $25 by exercising his option with Y.
X purchases an option for a barrel of oil from Y on November 1st in which X obtains the right but not the obligation to buy a barrel of oil for $100 on December 1st. On December 1st, the price of a barrel of oil is actually $115 and the option is exercised so Y must sell X a barrel for $100. X thereby saves himself $15 on a barrel of oil with this option investment.
In sum, the main difference between American and European option styles is that American options can be exercised on or before the expiry time and European options can be exercised at expiry time only.
Since American-style options can be exercised at various times before the option’s expiry, it’s important to know when to exercise an American-style option. In order to do so, many people subscribe to options trading signals which offer an indication of when the markets provide a prime opportunity to exercise the options and cash in on the option’s underlying asset.
Now that we’ve established what an option is and how financial options are used in the global financial markets, understanding the way binary options function and the way they are used by traders around the world will be much more intuitive.