Binary Outcome

By Fool.com

Image: Christiaan Colen

A binary outcome is a general term that implies there are only two possible outcomes to a certain situation. Binary outcomes have applications in several fields, such as computer science where a "bit" is a binary outcome -- the value is either 0 or 1, and a series of bits are combined to make up data. There are also numerous statistical and mathematical applications of binary outcomes.

The concept of a binary outcome can also be implied to business and investing to situations where there are two potential results, one positive and one negative.

Speculative stocksThere are certain stocks that investors go into with all-or-nothing expectations, and some pharmaceutical stocks are good examples of this.

If you buy shares of a pharmaceutical company whose only product is still in development, there are really only two ways it can play out. Either the company's drug will successfully obtain FDA approval, or it won't. If the FDA approves the drug, the share price could multiply several times over. On the other hand, if the FDA does not grant its approval, these companies' stocks can literally lose 90% of their value overnight.

The point is that with these types of stocks, there isn't much middle ground in terms of the end result. If you invest in a larger company, one good or bad news item may move the stock, but it won't make or break your investment.

OptionsOption trading is another excellent example of an investment with binary outcomes, particularly buying calls and puts.

For example, let's say that a stock you're watching is trading for \$50 per share, but you think it is grossly undervalued. So, you decide to buy call options that give you the right to buy shares for \$55 anytime within the next three months, and you pay a premium of \$1.00 per share to acquire the options.

There are a million different ways this trade could go, but all of them fall into two broad categories. On the positive side, the stock could be trading for more than \$55 on the options' expiration date (preferably above \$56, your breakeven point), which means that they will have some value. Or, the stock could stay under \$55 and your options will expire worthless.

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