What Are Binary Options?
Binary option refers to an option contract in which the payoff is either some fixed amount of certain asset or nothing at all. There are two types of binary options; cash or nothing binary option, and asset or nothing binary option.
In a cash or nothing binary option, if the contract expires in-the-money, then the owner receives some fixed amount of cash. An asset or nothing option, meanwhile, pays the value of the underlying security. Since these options have two possible outcomes, they are referred to as binary options. Binary options are sometimes also referred to as all or nothing options, digital options and fixed return options.
The potential return for the buyer of a binary option is certain and known before the contract is bought. The underlying asset in a binary option can be any financial product. Just like vanilla options, binary options have call and put options. Binary options are European style i.e. they can only be exercised at expiration.
Binary Call Options
The buyer of a binary call option is basically betting that price of the underlying asset will move above the strike price before the specified time. In this way, a binary call option is similar to a vanilla call option. However, the similarity ends here. While in a vanilla call option, the payoff can be unlimited if the price of the underlying asset moves above the strike price, in a binary call option the payoff is fixed if the price of the underlying asset moves above the strike price. If a binary call option expires out-of-money i.e. if the price of the underlying asset does not move above the strike price, the buyer of the option contract loses his entire investment.
Binary Put Options
Binary put options are bought when the price of an underlying security is expected to fall below the strike price. Just like a normal vanilla put option, a trader buys a binary put option if he is bearish on the underlying asset. Just like a binary call option, a binary put option also pays a fixed return if the option is in-the-money at the time of expiration.
Where are Binary Options Traded?
Initially, binary options were traded only on the OTC market. However, in 2008, the Securities and Exchange Commission (SEC) approved trading of binary options on exchanges. Shortly after SEC’s approval, binary options were listed on the American Stock Exchange (AMEX), and the Chicago Board of Exchange (CBOE).
AMEX offered binary options on some stocks and ETFs, while the CBOE offered binary options on the Volatility Index, known as VIX, and the S&P 500 Index.
Although binary options have moved from OTC market to exchanges, they are still thinly traded because of their complex nature.
Binary options trading on the AMEX are referred to as Fixed Return Options (FROs).
How a Binary Option Trade Work?
Let us look at an example of how a binary option trade actually works.
Suppose Bank of America Corp. (NYSE: BAC) shares are trading at $12 on Monday and a trader expects the stock to close at or above $12.50 at the end of the week, he will buy binary call options. Let’s say he buys, 10 binary call options at $100 each. Assuming that the payout is 70%, if the price of Bank of America shares rise above that level by expiration, then the option contract is in-the-money and the buyer of the contract will receive $1000 X 0.70 = $700 for the 10 option contracts. The initial investment was $1000 and the trader made a net profit of $700 on the trade.
Now let’s look at binary options from a put buyer’s perspective. Suppose a trader is bearish on Citigroup Inc. (NYSE: C) shares, which are trading at $40 at the moment, and expects the price to fall to or below $39 before the end of the week, he will buy binary put options. Let’s say the trader buys 10 binary put options for a total investment of $1,000, expiring at the end of the week. The payout is 80%. At the end of the week, Citigroup price falls to $38.50, then the option is in the money. The buyer of the binary put option will make a net profit of $800. ($1000 X 0.80).
Binary Options Vs Traditional Options
While there is significant trading in traditional or vanilla options, binary options are thinly traded even though they offer some advantages to a trader. One of the first advantages of binary options is that they may expire at any time interval unlike vanilla options, which expire at monthly or quarterly intervals.
The payoff in a vanilla option varies by how much the value of the underlying asset changes from opening to closing. On the other hand, the payoff for binary options is fixed. A trader buying binary options knows beforehand how much money he will make or lose.
Trade Types
Binary option trades can be classified into three main types; High/Low, In/Out, and Touch/No Touch.
A High/Low trade, also called Up/Down trade, basically refers to a type of trade in which the buyer of the option is predicting whether the market price of the underlying asset will end above or below the strike price before the expiration of the contract. High or Up trade is when the trader buys a binary call option and Low or Down trade is when the trader buys a binary put option.
The other trade type is In/Out trade, also known as tunnel trade, or the boundary trade. This type is used to trade price consolidations and breakouts. In this type of trade, a trader sets two price targets, forming a range. Once this is done, he will buy an option to predict if the price of the underlying asset will stay within the specified price range or the tunnel until expiration or if the price will breakout.
The final type of binary option trade is Touch/No Touch. In this type of trade, a trader is predicting whether the price of the underlying asset will touch a price barrier or not. A Touch trade refers to a trade in which a trader buys a contract that will make profit if the market price of the underlying asset touches the set target price at least once before the expiration of the contract. If the predicted price movement does not happen before the expiration of the contract then the trader will lose his investment. In a No Touch trade, the trader is predicting that the price of the underlying asset will not touch the strike price before the expiration of the contract.