Binary options 101. Read this first if you've never interacted with binary options before.

Why binary options?

Binary options enable users to go long or short on specific outcomes around price feeds and have some ingrained properties (or features) that make them a great contender to become the most popular derivative instrument.
They provide:
  • Easy to understand and relatable model (sports betting).
  • Limited risk environment with capped downside (no risk of liquidation on long calls).
  • Near expiry a great amount of leverage.
  • Flexibility to customize bets and create markets.
  • A varied offer of events that can be speculated upon, including traditional financial instruments, crypto assets, and sports betting.
Also, it enables all potential losses to be calculated at the start of the trade which is great for those that prefer tighter risk management.

Binary options structure

One feature of binaries is that at expiry, bets have a discontinuous distribution. In simple terms, this means that there is a “gap” between winning and losing with no in-between.
You either win or lose and settle your bet at either 1 or zero per binary options contract.
Note: Binaries whose condition is for the result to be “above” a defined price are sometimes referred to as“upbets”. In most circumstances, the reverse of the upbet is referred to as “downbet”.
Let’s take a look at this graph representing the price of a binary option contract, an upbet, where the trader went LONG on the YES option for this example asset to be above 101 USD at strike date.
Price of a binary option (upbet) in relationship to the price of the underlying at expiry.
The possible scenarios when the strike date hits:
1) The underlying asset is above 101 USD (“in the money”), making the upbet a winner and giving it a value of 1.
2) Alternatively, if the underlying asset is below 101 USD, then the bet has lost having no value. This is also called “out of the money”.
There is a third, very rare, case when the underlying finishes exactly at the strike price on strike date. The current smart contract logic supports resolving markets in favor of long options for cases where the underlying price is strictly equal to the strike price to two decimal points.
It’s important to note that the price of the underlying can be above the strike price at any time (in the case of an upbet) or below the strike price (in the case of a downbet), but it’ll only count for the settlement of the bet at the strike date.
Since the price of a binary option is constrained by the limits of 0 and 1, then you can easily calculate your expected win or loss at the inception of the trade.

Binary options profit & loss calculations

People that purchase binary options can only lose the amount they spent on the premium.
If we take the previous example and imagine the trader paid 30c per token on that upbet, and he bought 1000, then the maximum he can lose is what he paid, 300 USD (-100% ROI).
The potential profit is also capped, if we assume no trading, at 700 USD (233% ROI).
If we come back to the possible scenarios and we add the potential profit and losses we get these outcomes:
1) If the underlying is above 101 USD at the strike date, then the trader generates a 700 USD profit. Spending 300 USD for the options then winning 1000 USD when exercising it.
2) Conversely, if the underlying is below 101 USD at the strike date, then the trader losses 300 USD, which he invested originally.