Definition and types
A Binary option is a type of option where the payoff is either fixed amount of some asset or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security. Thus, the options are binary in nature, because there are only two possible outcomes. They are also called all-or-nothing options, digital options, more commonly met in forex and interest rate markets, and Fixed Return Options (FROs), seen on the American Stock Exchange. Binary options are generally European-style options.
When buying a binary option the potential return it offers is reliable and known before the purchase is made. Binary options could be bought on virtually any financial product and in both directions of trade either by buying a Call/Up option or a Put/Down option. This means that an investor can go long or short on any financial product simply by buying a binary option. Binary options are offered against a fixed expiry time which may be e.g. 5-30 minutes in the future, an hour ahead or at the close of the trading day. Once you have bought binary options, they cannot be resold before the expiry time is reached.
Let’s say that a purchase is made of a binary cash-or-nothing call option on XYZ Corp’s stock struck at $100 with a binary payoff of $1000. Then, if at the future maturity date, the stock is trading at or above $100, $1000 is received. If its stock is trading below $100, nothing is received.
Non exchange-traded binary options
Binary options contracts have long been available over-the-counter (OTC), i.e. sold directly by the issuer to the buyer. They were usually considered to be exotic instruments and there was no liquid market for trading these instruments between their issuance and expiration. They were often seen embedded in more complex option contracts.
Since mid-2008 binary options websites called binary option trading platforms have been offering a simplified version of exchange-traded binary options. It is estimated that around 90 such platforms have been in operation as of January 2012, offering options on some 125 underlying assets.
The platforms offer standardized short-term binary options with a pre-determined profit/loss, that could not be liquidated before expiry. The platforms do not charge fees from their investors. Their profit comes from the difference between the options that expire in the money to options that expire out of the money. However, these platforms may be considered by some as gaming platforms rather than investment platforms, because of their negative cumulative payout, they have an edge over the investor, and because they require little or no knowledge of the stock market to trade in.
Exchange-traded binary options
In 2007, the Options Clearing Corporation proposed a rule change to allow binary options, and the Securities and Exchange Commission approved listing cash-or-nothing binary options in 2008. In May 2008, the American Stock Exchange (Amex) launched exchange-traded European cash-or-nothing binary options, and the Chicago Board Options Exchange (CBOE) followed in June 2008. The standardization of binary options allows them to be exchange-traded with continuous quotations.
Reading source: Wikipedia