Posted on 24 July 2012.
In order to understand binary options, an investor needs to understand call options. A call option is the right of an investor to buy a commodity as a specified price during a specified time period; this privilege costs money to purchase, but it effectively hedges risk by only requiring a tie up of a small portion of an investor’s buying power. A binary option is almost like gambling, because it is an all or nothing scenario.
Call option contracts have three very important pieces of information: What is being bought, how much it is being bought for, and the time limit on when the product can be bought. Binary option contracts are similar, but they also have a fourth piece of information known as the payoff. The payoff is how much the option is worth should the commodity end up being worth more than the specified price at the end of the time period. For example, let us say that a binary option is purchased on oil at $75 a barrel with a payoff of $500 for three months. If at the end of that three month period, oil is trading for more than $75 a barrel, then the investor would earn the payoff of $500; if the opposite is true and oil is under $75 a barrel, the investor gets nothing.
Binary options are more like gambling than a safety net. With a call option the investor is trying to hedge his risk in the commodities market, while the binary option is just a speculation and a gamble. It can be a profitable venture, because it does not require a large sum of money should the option turn profitable. A person who exercises a call option has to have the ability to buy the commodities contract, while the binary options simply allow the person to gamble on the commodity.
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