A option is a financial contract that gives the buyer the right to buy or sell an asset for a specified price (strike price) on or before a certain date (expiration date). A call option allows the holder to buy the underlying asset on or before the date. A put option allows the holder to sell the asset for that price on or before the due date. Options are valued according to the difference between the strike price and the current market price of the underlying asset.
Options are used widely in financial markets to hedge or speculate on the price of an underlying asset with a quantified risk. Complex financial instruments can be built using combinations of buying and selling call and put options with different strike prices and expiration dates.
A binary option is a simple type of option that is valued according to a true/false statement. For example if the price of the underlying asset is above a certain level the call (long) option will pay 100, if it is below it will pay 0. For a put option the reverse is true.
Binary options make for simple valuation and are therefore a good way for traders to avoid complicated valuation, which often work in favour of option issuers to the detriment of buyers.
Binary options have become a popular way to trade major financial markets online.
Binary Options and Bitcoin
With the popularity of Bitcoin and its acceptance as a currency binary options platforms began adding BTC as one of the currencies to trade. This has further helped the growth of binary platforms as well as mainstream recognition of Bitcoin as a currency. Most brokers only offer it as a currency pair versus the American Dollar.
Bitcoin Binary Option Smart Contracts
Bitcoin allows the creation of smart contracts for binary options. The contract itself holds the funds in escrow and on expiry date pays all the funds to the Bitcoin address that was on the correct side of the true/false statement.
This allows the complete elimination of counterparty risk. The solvency of the option issuer is irrelevant if the funds are already locked in the contract itself. It is irrelevant if the company or party that issued the option disappears, defaults or wants to change the terms of the contract. The elimination of counterparty risk allows long-term financial contracts in a trust-minimized way.
Smart contracts rely on an oracle to verify external conditions.
- Alice and Bob each send 1 BTC to the contract 2-of-3 multisignature address which is controlled by private keys K1, K2, K3.
- Alice holds K1
- Bob holds K2
- Oracle holds K3.
- On expiry if condition is TRUE the oracle sends K3 to Alice. Alice withdraws 2 BTC.
- On expiry if condition is FALSE oracle sends K3 to Bob. Bob withdraws 2 BTC.
The mechanism is very similar to an escrow contract but instead of a mediator holding the third key the oracle holds it and can resolve automatically based on simple true/false conditions. Ideally to prevent it from being compromised or targeted, the oracle would be a simple automated system unaware of the information that it was sending. It would only know to send an encrypted e-mail to Alice if true, to Bob if false.
Reality Keys details a slightly more complex way of doing this which allows funds to be sent to Alice or Bob depending on a conditional: Conditional payments using branching bitcoin transactions.
OP_IF 2 A-pub Yes-pub 2 OP_CHECKMULTISIG OP_ELSE 2 B-pub No-pub 2 OP_CHECKMULTISIG OP_ENDIF
How To Trade
Trades are placed by predicting the direction an asset will move during the specified time frame. The time that option ends is called an expiry time. Expiry times range anywhere from 30 seconds until months away. At the end of the time if the direction you chose was correct, you win the trade. Winning trades pay out slightly less than 100% and typical payouts range between 80-85% depending on the broker.