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Binary Options - Definition
Exotic Options which pays a fixed return when it finishes in the money upon expiration.
Binary Options - Introduction
Binary options, also known as Digital Options, All or Nothing Options or Fixed Return Options, are definitely one of the most popular type of exotic options ever. They are extremely popular in forex options trading and has since 2008 been approved for listing in the US market on several stocks, indexes and ETFs.
Unlike regular plain vanilla options, Binary options pay a fixed return as long as the options finish in the money by expiration no matter how much in the money. It is like placing a bet for a specific amount of money on the underlying asset finishing higher or lower than a specific price.
This tutorial explores what Binary Options are, how they are traded, how they are priced and how they work. (Read about Can You Really Get Rich Trading Binary Options?)
What Exactly are Binary Options?
The reason why Binary Options are "Binary" is because trading binary options leads to only two possible outcomes; Winning a specific fixed amount of money or losing it all. Like plain vanilla options, Binary options comes with call options and put options as well. When you buy Binary Call Options, you win a specific amount of money when the underlying asset ends up higher than the strike price (in the money) upon expiration and when you buy Binary Put options, you win a specific amount of money when the underlying asset end up lower than the strike price upon expiration. You lose it all (or a fixed amount) if the stock does not.
In terms of ending up out of the money by expiration, Binary Options are exactly like Plain Vanilla Options which simply expire out of the money and you lose your entire investment in the position. However, you can actually win varying amount of money when plain vanilla options end up in the money by expiration depending on how much in the money it moved while you can only win a fixed amount of money buying Binary Options. This is why there are only two fixed outcomes for Binary Options.
In essence, buying Binary Options is placing a bet on whether the underlying asset would be higher or lower than its strike price by expiration. This is also why Binary options are usually offered at the money with a 50/50 chance of ending up either way.
Binary Call Options
Binary Call Options are Binary Options betting on the price of the underlying asset rising above the strike price. Like normal call options, they are bought when you are bullish on the underlying asset. Buying Binary Call Options pays you a fixed return when the underlying asset ends up higher than the strike price upon expiration. Returns are usually expressed as a percentage of the original investment. If the underlying asset finishes lower than the strike price, you lose your entire investment in the position or a certain percentage of it.
There are two kinds of Binary Call Options; Cash-Or-Nothing Call and Asset-Or-Nothing Call. Cash-Or-Nothing call returns a fixed return in cash while Asset-or-Nothing call returns a profit equal to the price of the underlying asset.
Binary Put Options
Binary Put Options are Binary Options betting on the price of the underlying asset falling below the strike price. Like normal put options, they are bought when you are bearish on the underlying asset. Buying Binary Put Options pays you a fixed return when the underlying asset ends up lower than the strike price upon expiration.
Similarly, there are two kinds of Binary Put Options; Cash-Or-Nothing Put and Asset-Or-Nothing Put.
Binary Options Strike Price
Binary Options usually comes with only one strike price, which is the prevailing price of the underlying asset. This makes these Binary Options at the money at the point of purchase. For instance, if you bought a binary call option when AAPL is trading at $200, the strike price of that binary call option would be $200. Such Binary Options are always bets on the underlying asset being higher or lower than the prevailing price of the asset when you bought the binary options.
Exchange Traded Binary options listed in the US market comes with multiple strike prices just like plain vanilla options. This allows the options trader to choose varying degrees of risk exposure and profit probability. In fact, most exchange traded binary options listed in the AMEX shares the same strike prices as their plain vanilla counterpart.
Binary Options Pricing
Binary options are priced using the black-scholes model and quoted in dollars and cents just like plain vanilla options and range from $0.00 to $1.00. A binary option quoted at $0.50 with contract size of 100 requires an investment of $50 per contract.
Pricing of Binary Options Derived from Delta
The price of Binary Options indirectly imply the probability of those binary options ending up in the money. For instance, a binary option priced at $0.70 is implying a profit probability of 70%. As such, the price of a binary option is usually consistent with the delta value of their plain vanilla counterpart while the delta value of a binary option is consistent with the vanilla's gamma value. This means that the price of Binary options increase towards $1.00 as they get more and more in the money and decreases towards $0.00 when they get more and more out of the money. In fact, the price of exchange traded binary options in the AMEX closely shadows the delta value of plain vanilla options of the same type and strike on the same underlying asset. For instance, if the $200 strike price plain vanilla call options of GOOG listed in the AMEX has a delta value of 0.80, its $200 strike price binary call options would be trading at around $0.80.
Put Call Parity of Binary Options
Since the price of Binary options reflect the probability of the options ending up in the money by expiration, put call parity in binary options are reflected in the fact that the ask price of one option and the bid price of the other at the same strike price will always be equal to $1. This represents the fact that if you are long in both binary call and put options, you are guaranteed a win of one side but you also won't have made any money since you already paid the maximum possible payout of $1 or more.
The picture below is the actual binary options chain for the VIX Binary Options, BVZ on 25 March. If you add up the ask price of one option with the bid price of the other at the same strike price, you will always get $1. This is put call parity in Binary Options and is expressed in the formula : C + P = Betr where C = Price of Call, P = Price of Put and Betr = Fixed Payout
For example, adding the ask price of the $20 strike call options and the bid price of the $20 strike put options gives you $0.44 + $0.56 = $1.00. Similarly, adding the ask price of the $20 strike put options with the bid price of the $20 strike call options gives you $0.68 + $0.32 = $1.00.
The bid ask spread of Binary options also made sure that there are no arbitrage opportunities no matter if you bought both call and put options or wrote both call and put options. If you bought both call and put options at the same strike, you would have paid more than $1.00 (while maximum payout is $1.00) and if you wrote both call and put options at the same strike, you would have recieved lesser than $1.00 (while you would have lost $1.00).
How Market Makers for Binary Options Make A Profit
The bid ask spread is also how market makers or brokers offering Binary Options make a risk free return. By selling both call and put options at the same strike price on the ask, market makers or issuers recieves more than $1.00 while all they pay out for that pair is a maximum return of $1.00 (since only either the call or the put at the same strike price can end up in the money). For instance, if market makers sold the above $20 strike price binary call and put options, they would recieve $0.44 + $0.68 = $1.10 while they would eventually pay out $1.00 and make a risk free $0.10 per pair.
Binary Options Expiration
Unlike plain vanilla options, Binary options have various expiration periods from as short as a few minutes to as long as a few months depending on the market and the underlying asset. Exchange-Traded Binary Options listed in the US market usually comes with 3 front month expirations while binary options traded in the forex market may have expirations as short as an hour or a few minutes.
Binary Options Exercise Style
Binary options are either American Style or European Style depending on the market and the underlying asset.
Unlike American Style plain vanilla options, American Style Binary Options are automatically exercised the moment it gets in the money. This means that the holder do not have to wait until expiration in order to realise the full profit. This is why American Style Binary Options are sometimes known as "One-Touch" Binary options.
European Style Binary Options are Binary options which can be exercised only upon expiration. This means that the holder only realise its full profit if the options are held all the way to expiration and are in the money. Most binary options being traded are European Style.
Binary Options Settlement Style
Binary options comes with both physical settlement and cash settlement as well. Physically settled Binary Options are known as Asset-Or-Nothing options and cash settled Binary Options are known as Cash-Or-Nothing options.
Most binary options are Cash-Or-Nothing options and are settled in cash. However, there are some physically settled binary options being traded that returns the actual underlying asset or a cash value based on the price of the underlying asset.
Margin for Writing Binary Options
When writing of binary options are allowed, like exchange traded binary options, margin would also be required. However, due to the fact that the payout for binary options are fixed, the exact risk exposure of each position can be precisely calculated, resulting in lower margin requirement than writing naked options on plain vanilla options.
The margin required for writing binary options is simply the difference between the premium recieved and the maximum payout.
Binary Options Margin (writing) = Payout - Premium Recieved
This ensures that the cash needed for the payout on a losing trade is always available.
In fact, the margin requirement is always equal to the ask price of the opposite option at the same strike price if put call parity is strong. If you look at the binary options chain for BVZ above, you would notice that the margin requirement of $0.68 for writing BVZ's April$20Call is equal to the ask price for its April$20Put.
Exchange Traded Binary Options
Binary options were approved for listing in the US market by the SEC in 2008. In that year alone, the American Stock Exchange (AMEX) and the Chicago Board of Exchange (CBOE) both listed standardized exchange traded binary options. AMEX listed exchange traded binary options on some stocks and ETFs while the CBOE listed exchange traded binary options on the Volatility Index (VIX) and the S&P500 (SPX). Exchange traded binary options have standardized terms which allows them to be traded across different exchanges. Currently, exchange traded binary options are still thinly traded due to lack of understanding in this new instrument. In fact, traders all over the world are just getting to understand plain vanilla options and might take a while before trading of exchange traded binaries becomes significant.
Even though the terms and specifications are largely the same between the AMEX and CBOE listed binary options, the terms used by AMEX are slightly different. In the AMEX, exchange traded binary options are known as Fixed Return Options or FROs. Binary Call Options are known as "Finish-High" options (due to the fact that profit occurs when the underlying asset finish higher than the strike price) while binary put options are known as "Finish-Low" options (due to the fact that profit occurs when the underlying asset finish lower than the strike price). Also, even though the settlement price of plain vanilla options in the AMEX is based on the actual price of the underlying asset itself, the AMEX FROs actually derive their settlement price from what is known as a "Settlement Index", much like how settlement prices are calculated in futures trading. So it is actually possible for plain vanilla options and binary options of the same strike price and underlying asset to have a different options moneyness. Every exchange traded binary option listed in AMEX comes with its own settlement index. For instance, AAPL binary options are based on the AMEX FRO Settlement AAPL index and Citibank binary options are based on AMEX FRO Settlement C index instead of the price of the stock itself.
Exchange traded binary options in the US market can also be bought or written just like their plain vanilla counterpart. Options traders writing a binary option recieves the premium and loses the payout. This makes writing exchange traded binary options a trade with limited profit potential and limited risk. However, the reward/risk ratio of writing binary options is always lesser than 1 due to the fact that the writer would always stand to make a higher potential loss than gain.
This kind of odds really makes buying binary options more sensible in terms of reward risk ratio than writing them.
Exchange Traded Binary Options Specifications
All exchange traded binary options in the US market share the same core specifications as laid out below:
Exercise Style : European
Contract Size : 100
Expiration Months : Front 3 Months
Settlement Style : Cash Settlement
Binary Style : Cash or Nothing
Payout : $1.00
Price Quotation : $0.00 to $1.00
Hedging using Binary Options
Like plain vanilla options, Binary options can be used for hedging as well as speculation. In fact, Binary options have been popularly used for hedging profitable forex positions and for extending profitability in the case of small pullbacks.
When used as a hedge on a long position, buying binary put options outshines buying plain vanilla put options when a limited pullback in the price of the underlying asset is expected. Buying binary put options returns the full return as long as the underlying asset drops below its strike price while the underlying asset has to drop enough to overcome the extrinsic value of plain vanilla put options before the protection kicks in. As such, plain vanilla put options are ideal for protecting against huge catastrophic drops. Buying binary put options as hedge is also better than writing plain vanilla call options due to the fact that no margin is needed and that upside profitability above the strike price of the put options remains open.
Comparing the three hedging methods above, it is clear that buying Binary Put options is an ideal hedging method if the underlying asset is expected to pullback slightly and not limit further topside profit potential.
The drawback to hedging using Binary options is that the price basis of some binary options isn't the price of the underlying asset itself but an index based on the underlying asset which may not track the exact price movement of the underlying asset.