Anybody's who ever studied options long enough to learn about the "Greeks" (gamma, delta, vega) knows that a subject that seems simple to become essentially complex in practice. Binary options seem to simplify a traders life. Of course, they do not come without risk.
Basically, they're called "binary" because there are only two, either-or results. If you win, you win one set amount of money. If the underlying security's market price is not in the money by expiration, you lose the money you paid.
They're also called all-or-nothing, digital, and fixed-return options (those listed on Amex). Most of them are European-style, which means you can not exercise an option until after expiration. Typically, American-style binaries are exercised automatically if the under security security touches the strike price.
These types have been available over the counter. In 2007 the Options Clearing Corporation proposed a rule change to allow them. This was approved by the Securities and Exchange Commission (SEC), and so trading in binaries began on the American Stock Exchange and the Chicago Board Options Exchange in 2008. You can also buy them for forex trades.
They're priced between 0 and $ 1, with a time 100 multiplier. Tick size is $ .01.
Their price is set by the market's estimate of the probability that the underlying market price will reach the strike. Thus, if the price is $ 60 that reflects the market as a whole believes the odds of the underlying market price reaching striking by expiration is 60%. If you buy this option and market price reaches strike before expiration, you receive $ 100. Therefore, your profit would be $ 40.
However, that $ 60 option price means that the market estimates that the odds of the undering's market price failing to reach strike before expiration is 40%. If that happens, you lose. Your loss is the $ 60 you paid plus, of course, the commission charge.
This simple structure makes it easy to determine your risk / reward ratio. You risk the market price of the option. Your reward can be $ 100.
The other big difference between them and conventional options is time. Binaries are just for a short period, even hours. Therefore, the calculation of time decay is not so important. Any one you buy is going to expire in just a short time.
Therefore, the real key to success in trading these options is calculating the "true" odds that a given security's market price will reach strike by expiration. And then in identifying cases where the market is significantly over or underestimating that probability. If you believe that the security's price is more likely to reach strike by expiration, buy it.
If you're correct, you're making a good bet. Make enough good bets and you'll win enough to make a healthy profit. The laws of probability will reward you for taking a bet where the payoff is greater than the true odds of success.
Of course, to successfully trade these binary options, you must really have a system to identify trades where you have the edge. That means, you must really be smarter than the market as a whole.