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Reviewed by Jul 26, 2021| Updated on
A binary option is an unconventional financial option where the payout is either a fixed monetary sum or absolutely nothing. The two main kinds of binary options are the asset-or-nothing binary option and the cash-or-nothing binary option.
The former pays a fixed amount of cash if the in-the-money option expires while the latter pays the value of the underlying security. They are also referred to as digital options (more popular in forex/interest rate markets), fixed return options (FROs) (on the American stock market), and all-or-nothing options.
Binary options vary in that they do not offer the opportunity to take a position in the underlying asset. Usually, binary options provide a maximum fixed return, while the maximum risk is limited to the amount invested in the option. Movement in the underlying asset does not change the earned payment, or any damage sustained.
The profit or loss depends on whether the underlying price is on the right side of the strike price. Some binary options can be closed before expiry, although this usually decreases the earned payout (if the option is in the money).
Binary options are often seen as a form of gambling rather than investment due to their negative cumulative payoff (since brokers have an advantage over the investor) and are marketed as having little or no market knowledge.
While a binary option can be utilised in theoretical asset pricing, they are vulnerable to fraud in their implementations and are therefore banned as a form of gambling by regulators in many jurisdictions. Several binary option outlets have been exposed as illicit in nature.
Occasionally, binary options trade on platforms which are regulated via the Securities and Exchange Commission (SEC) and various other regulatory agencies. However, most binary options trading happens out of the United States and might not be regulated.