In order to understand binary options it is useful to get a general idea of what a traditional option is and how it works.
The "regular" options are contracts where the buyer pays for the right to buy or sell an underlying asset at a given price, whereas a binary option is a contract where the buyer pays for the right to receive a fixed return in case the price of the underlying asset ends up above or below the strike price.
Indeed, binary options are not options in the traditional sense of the word, because unlike the original instrument, binary options do not give you the right to buy or sell the underlying asset, but instead they only give you the right to get a fixed return (usually around 65%-81%) .
So, let us say that you want to buy a CALL option on Google, if you buy a regular option contract, and the price of the stock ends up above the strike price by the expiration date (which is the 3rd Friday of each month), then you will be able to exercise the right to purchase the stock at that price regardless of its current trading price.
In this case your profit could come in two ways:
1. You could sell the "in the money option" before expiration and make a profit from the difference between the purchase price of the contract and the selling price (which will obviously be higher because it is in the money).
2. You could simply wait until the contract has expired and buy the stock at the price of the strike and then sell it at the trading price thus making a profit from the difference between the strike price and the trading price.
In both cases your profit will depend on the magnitude of the movement in the price of the stock.
However, it is important to note that if your contract expires out of the money it becomes worthless and you would lose 100% of your investment in this case.
Now, if you where to buy a binary CALL option on Google your profits would realize in a completely different fashion:
1. Binary option contracts do not expire monthly, but hourly or daily, which means that your profits (or losses) realize within these time frames.
2. A binary option contract will pay you the fixed return (usually between 65%-81%) regardless of the magnitude of the movement in the price of the underlying asset, as long as it expires in the money by at least $0.001.
This is the very reason why binary options have their name, because the outcome is always black or white, "all or nothing" even if your contract ends up " in" or "out" of the money by a cent, if you are in the money you get the full return (65%-81%) and if you are out of the money you get to recover only around 5% or nothing depending on the broker.
With binary options it will not matter if Google shares went up $1 or $40 above the strike price of your contract (assuming you purchased a CALL option), you will get paid the same return either way, whereas in a traditional option contract your return will depend entirely on the magnitude of the movement in the price of the stock.
So, binary options are contracts with a life span of one hour or one day that you can buy on certain assets like stocks, currencies, indexes or commodities, where your right is always limited to a fixed return in case they expire in the money by at least one cent.
