Out-of-the-money (OTM) binary options may seem confusing at first but after reading this brief explanation hopefully things will clear up.
For the binary option there is an underlying market price and a binary strike price level.
As a binary buyer, at expiration you are predicting that the underlying price will be trading higher than the particular binary strike price level. If you predict correctly, then at expiration the binary will settle at 100 and you will receive $100 per contract (exchange fees not included)
In simple terms, if you buy a binary strike that is above the underlying market price then you’re buying an OTM binary. At expiration the underlying market price has to be trading above the strike for the binary buyer to receive the settlement payout.
The farther the underlying market price is below the strike level, the more of a trade disadvantage the binary buyer has when initiating a trade.
Remember binary pricing for each binary strike level will trade between 0 and 100.
So to transition from a binary trade disadvantage means that the binary buyer will have a cheaper initial cost or a lower trade price relative to the 0 to 100 price range.
Compare the two binary strike below when the spot EUR/USD underlying is trading at 1.0831
EUR/USD >1.0900 offer price at 12.75
EUR/USD >1.0860 offer price at 31.25
For the EUR/USD >1.0900, the difference between the 1.0900 strike and the underlying spot EUR/USD at 1.0831 is 69 pips. That means the spot EUR/USD has to rally more than 69 pips before expiration, which is a big disadvantage compared to the other strike. For that reason the binary price is much less compared to the other strike.
The EUR/USD >1.0860 strike has less of a trade disadvantage as the difference between the 1.0860 strike and the underlying spot EUR/USD at 1.0831 is only 29 pips. That means for the binary buyer to receive the settlement payout, the spot EUR/USD has to rally more than 29 pips at expiration. The reason this strike is priced higher at 31.25 is that the immediate trade for a binary buyer is less under water.
Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results.