Options allow investors to take positions based on their views of the direction a certain investment will move in the near future, and binary options refine that position into a simple yes or no proposition. Binary options are contracts in which there are only two outcomes: either the option buyer gets paid a certain fixed amount at expiration, or the option buyer gets nothing.
Unlike many traditional options, binary options are purely financial in nature in that there's no change of ownership of shares of stock or other underlying investments. The risk involved for the buyer of binary options is limited to the amount of premium paid to the option seller, and the seller's risk is also limited to the agreed-upon fixed payment if the price of the underlying security moves in accordance with the option's terms. That's much different from traditional options, in which the option seller often has potentially unlimited risk of loss.
How binary options work
Each binary option has several characteristics. The option must refer to an underlying security, which can be an individual stock, a commodity, a financial index, or anything else that has a market-determined price. The binary option also has a fixed price, known as the strike price, that triggers the payment under the contract.
Binary call options pay out if the price of the underlying security at expiration is greater than the strike price, and pay nothing if the market price is less than the strike. Binary put options work the opposite way, paying nothing if the market price is higher than the strike price, but paying the specified amount if the market price falls below the strike price.
A limited number of binary options are available on regulated exchanges. For instance, the CBOE offers binary options on the S&P Volatility Index (VOLATILITYINDICES:^VIX), also known as the VIX.
As an example, say the VIX is at 16, and you think that it will move above 20 within the next month. You can buy a binary option that would pay out $100 for every option contract if the VIX hits 20 at expiration, or pay nothing if the VIX is below 20 at that time. The CBOE prices its options in pennies between $0 and $1, and so you pay whatever the option price is times 100 for each contract. In this example, the price might be 0.20, so you'd pay $20 per contract.
Why binary options get criticized
There are several reasons why binary options don't have the same reputation that traditional options have. First, because binary options don't involve underlying securities, they don't offer the same sort of risk-reduction strategies that traditional options allow.
The fixed payout, in particular, makes binary options resemble a straight gambling wager, which many investors believe is inconsistent with the function of the market. The fact that some binary options have expirations measured in hours rather than months only heightens the sense that they are meant for short-term traders rather than long-term investors.
More notably, a substantial portion of the trading of binary options happens on unregulated exchanges. There have been reports of fraud and other questionable behavior occurring in the binary options markets, and regulators like the Securities and Exchange Commission and the Financial Industry Regulatory Authority have warned investors about the dangers of using binary options.
Binary options are an interesting innovation, but their relative lack of availability on regulated exchanges shows that they haven't caught on with investors. Until they gain more acceptance, investors should be careful in dealing with binary options and the companies that promote them.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.