Binary Options Vs. Vanilla Options

Binary options vs vanilla.
If you ask a professional trader about currency or other asset options, he/she will assume you are talking about a vanilla option or some exotic form of it (e.g. one touch, no touch, etc.). On the other hand, if you ask a retail trader about options, he/she will likely assume you are talking about binary options. What the two have most in common is the word options. This is where the similarity ends. What are binary options? A binary option gets its name from the term binary, which is the way computers store and calculate data. Computers use only two digits, zero and one. For example, zero = true and one = false so it is either one digit or the other. In binary options, there is also an either/or outcome, which means the option expires in the money (winner) or out of the money (loser). There is also a fixed payout for ending in the money and a fixed cost when it ends out of the money so the buyer knows his/her risk or reward beforehand. Some say this is an all or nothing outcome although brokers may pay out a small percentage when the trade expires as a loser. Buyers of binary options are either looking for it to go up (call) or down (put) within a period specified at the time the trade is put on. The time is chosen at the time of the trade and can vary from as short as 30 seconds to as long as 24 hours. This means the buyer not only has to choose an entry price but also the direction and time the option will expire. What are vanilla options? Unlike its cousin in name only, vanilla options do not have a fixed payout as prices are constantly changing as they are based on movements and volatility of the underlying asset as well as time decay to expiration. The buyer, however, can sell the option at any time before then to liquidate the position. A vanilla options price will approach the price of the underlying asset at the time of maturity. In addition, vanilla options can be sold as well, which entails different risks. While the buyer can only lose the cost of the option (i.e. the premium), the seller can lose more than the premium he/she would collect if the market moves through the strike price and then beyond. However, the seller can only earn the cost of the premium. So theoretically, a seller has unlimited risk and a limited reward while a buyer has a limited risk and unlimited reward. However, the time decay can work against the buyer, especially if volatility does not increase. Professional options writers (sellers) hedge the position to limit the outright risk but that is for another discussion. Why do retail traders prefer binary options? Retail forex traders generally prefer to trade binary options over vanilla options for several reasons. 1) Binary options are straightforward, easier to understand and trade, 2) Traders know their risk in advance so there is no need to constantly monitor the screens. 3) There is more flexibility in time frames for expirations. 4) Traders can get quicker results than in vanilla options, which generally have a longer time horizon. However, it is not a one way street as vanilla options offer a bigger upside while binary options have a fixed payout. In addition, there is the flexibility to be a buyer (owner) or a seller (writer) of a vanilla option although as noted, the latter entails more risk. In any case, retails traders seem to prefer binary options for the reasons cited above but should be treated as a business and not gambling, which is a subject for a future discussion.
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