The price or premium of a binary option is defined as the amount paid to purchase a Call and Put binary option based on a particular underlying asset, i.e. the price of an option contract. In other words, the premium is the cost incurred by the trader by operating with binary options and at the same time is the maximum loss that he can experience if the option expires Out the Money and does not make any profit from the operation. The broker determines the premium to be paid by the trader on the basis of a number of established factors, including the value of the underlying asset, the exercise price and the maturity time. Therefore the trader only has to accept or refuse payment of the premium, i.e. whether or not he wants to open the position.
Viewed differently, the premium is the amount invested by the trader in each transaction with binary options, being the money that allows us to purchase the contract of an option and gives us the right to receive a payment if our market forecast is met. In fact, binary option brokers express the potential benefit of an operation in terms of percentages of the premium that the trader has to invest in order to acquire an option. For example, if a broker tells us that a given Binary Option offers an 80% payment if it expires in the Money, this means that the trader can make a profit equal to 80% of the premium invested if everything goes as planned.
Because in most cases binary options are instruments that are OTC (i.e. that are traded in markets Over-The-Counter), contracts are not standardized as with other financial instruments. For this reason, the trader can invest virtually any amount, although this varies significantly depending on the broker and the type of binary option. Usually these companies establish a minimum investment of $ 10 or more and a minimum transaction size that can reach even $10,000. Therefore, before opening an account with a binary options broker the trader must investigate the limits set by the broker in the operations of its customers.
Calculation of the binary options premium
For the calculation of the premium of a binary option mathematical models are used which we will not touch in this article, which determine the value of the option based on different factors such as the price of the underlying asset, the maturity of the contract, the exercise price and others. In the following article we will talk more about this topic for those who are interested:
Assessment of binary options
Bonus on binary options brokers
However, for most traders it does not have the least interest as the premium of a binary option is calculated, as the way binary option brokers operate is such that the trader decides which amount to invest (premium) in an option to make a certain profit. The broker focuses on the benefits and not the cost of the option. On trading platforms brokers show the potential profit (as a percentage of the premium) for a Call binary option or Put based on an underlying asset A and with a maturity period B. If the trader considers that he can forecast the market direction for the B maturity period and also finds the payment offered by the option appropriate, then he can decide to buy a contract with a premium (money invested) whose value he can freely choose and which will depend to a large extent on how much money he has in his account.
In this way, the trader knows that in order to obtain an X gain with a given binary option, he must invest a Y premium in the option. For example, we see in the above image that the broker is offering a 65% payment for a binary Call or Put option based on EUR/USD. This means that if we invest $ 100 in the option, we can make a maximum profit of $ 65 if the option expires in the Money. In other words, a contract with this binary option that has a value of $100 can provide a maximum profit of $65 (65% of the premium), which informs the broker beforehand.
This model differs from that applied with traditional options. In this case, the broker offers the trader a specific premium for each contract that has a specific maturity date and exercise price. This premium is calculated using more or less complex mathematical models such as Black-Scholes. This is because traditional options differ significantly from binary options. In many cases they are standardized contracts that may have cash settlement or may condition the delivery of the underlying asset. In addition, they offer a level of unlimited potential that depends on both the direction and the magnitude of the movement. In other words, the trader can make a much higher profit than the value of the premium invested in the option.
Loss of premium in a binary option operation
As we saw earlier the option premium is the price paid by the trader to purchase the option and at the same time it is the maximum amount you can lose if the option expires Out the Money. It is also the money received by the broker by selling the contract and opening the position, and at the same time it is the profit he gets by the operation. In other words, the premium is the initial loss and gain of the trader and broker respectively, when the position is opened. In case the option ends in the Money, the trader receives back the premium plus a fixed and predefined profit (expressed as a percentage of the premium) while the broker has to return the premium received and pay the defined profit of the transaction, which means a loss for the company.
But if the option expires Out the Money, the trader receives no payment and loses the premium while the broker does not have to make any payment and retains the premium paid by the trader as a gain.
As with traditional options, in binary options the buyer loses all premium if the option ends Out the Money. However, in the case of the traditional options, the trader has the option of closing a position before the expiration of the contract (through the sale of the option) which allows you to reduce your losses or ensuring gains (options that are currently In The Money), which is not what you can do with binary options. In the latter, the trader has to wait until they expire to get a result and find out if he or she won or lost, although there are some binary options brokers that offer the trader the possibility to sell the option back to the broker before the expiration, so that they can limit losses or secure profits (See article on Sell Out service or Early Closure that offer some binary options brokers).