Some may wonder why the binary option came into being. In other words, what purpose do binary options serve in the global financial markets?
We have already shown what purpose an option can serve (click here to go to that article). Namely, it can help an investor hedge an investment by offering him or her the opportunity to purchase a commodity at a future date for a predetermined price.
So, what financial purpose does the binary option serve?
The basic financial principles underlying the binary option is that it can serve as an indication of the general public’s confidence or lack thereof in the value of a particular asset and it can also limit an investor’s risk by hedging a longer-term investment.
Let’s discuss how a binary option can indicate confidence in a financial asset with an example: if the vast majority of people purchasing binary options contracts on Microsoft stock are taking the position that the stock price will be LOWER than the current trading price in one week’s time, that is a strong indication that the overall sentiment of the trading public is that the value of the Microsoft stock is decreasing.
If, on the other hand, the vast majority of people purchasing binary options contracts on Microsoft stock are taking the position that the stock price will be HIGHER than the current trading price in one week’s time, that is a strong indication that the overall sentiment of the trading public is that value of the Microsoft stock is increasing.
This information can help inform traders and investors about the general sentiment on a specific asset in order for them to decide whether or not to buy or sell the asset in question.
Hedge long-term investment
Another financial purpose that a binary option can serve is that it can help investors hedge longer-term investments with a short-term one. Let’s say, for example, that Trader A takes a long position on EUR/USD meaning that he purchases euros under the assumption that the currency will increase in value vis-a-vis the dollar with the goal of then selling those euros at a profit.
Soon after purchasing the EUR/USD, Trader A realizes that his intuition on the euro rising in value may have been mistaken so he decides to invest in a DOWN position on an EUR/USD binary option that pays out 75% of the investment amount.
If Trader’s A initial assumption that the euro would increase in value was correct, he will profit from the long position on EUR/USD. If, however, his initial intuition was incorrect and the euro begins losing value vis-a-vis the US dollar, he will still profit from the DOWN position on the binary option contract in the short-term. Moreover, Trader A can then hold his long position on EUR/USD until the euro begins to gain value again.
In this way, Trader A has hedged his longer-term EUR/USD investment with a short-term binary option investment thus limiting the risk of an unprofitable investment.
Now that you understand what function the binary option serves, click here to read about the option brokers that offer binary option trading.