What are Binary Options?
A binary option, also known as a digital option or an all-or-nothing, is a trading product that offers a fixed return that is determined at the start of the trade. A trader will receive a predetermined payout if his binary option expires “in-the-money”, and he will lose a predetermined amount of his initial investment if the option expires “out-of-the-money”. The degree to which the option is in-the-money or out-of-the-money does not matter as it does with a traditional option. All assets such as currencies, stocks, commodities, and indices can be underlying assets for binary options.
There are two kinds of binary options:
» Exchange Traded binary options
» Non-Exchange Traded binary options
Exchange Traded binary options
In 2007, the Options Clearing Corporation proposed a rule change to allow binary options and the Securities and Exchange Commission approved listing cash-or-nothing binary options in 2008. In May 2008, the American Stock Exchange (Amex) launched exchange- traded European cash-or-nothing binary options, and the Chicago Board Options Exchange (CBOE) followed in June 2008. The standardization of binary options allows them to be exchange-traded with continuous quotations.
Amex offers binary options on some ETFs and a few highly liquid equities such as Citigroup and Google. Amex calls binary options “Fixed Return Options”; calls are named “Finish High” and puts are named “Finish Low”. To reduce the threat of market manipulation of single stocks, Amex FROs use a “settlement index” defined as a volume-weighted average of trades on the expiration day. The American Stock Exchange and Donato A. Montanaro submitted a patent application for exchange-listed binary options using a volume-weighted settlement index in 2005.
CBOE offers binary options on the S&P 500 (SPX) and the CBOE Volatility Index (VIX). The tickers for these are BSZ and BVZ, respectively. CBOE only offers calls, as binary put options are trivial to create synthetically from binary call options. BSZ strikes are at 5-point intervals and BVZ strikes are at 1-point intervals. The actual underlying to BSZ and BVZ are based on the opening prices of index basket members.
Both Amex and CBOE listed options have values between $0 and $1, with a multiplier of 100, and tick size of $0.01, and are cash settled.
Non Exchange Traded binary options
Binary option contracts have long been available Over-the-counter (OTC), i.e. sold directly by the issuer to the buyer. They were generally considered “exotic” instruments and there was no liquid market for trading these instruments between their issuance and expiration. They were often seen embedded in more complex option contracts.
Unlike traditional options, binary options do not have set prices–the trader decides the amount of money they want to risk and invests that amount when they buy the option. The time of expiration for binary options are set at different time intervals throughout the day, such that at any time a trader can purchase an option that will expire in 1 month, 1 day, 1 hour or even 5 minutes. The shorter duration of the contracts makes binary options more suitable for short-term, intraday trading than their traditional counterparts.
An example of a typical binary option trading:
In the morning at 10am a trader reads the morning news and sees that the price of oil, trading at 100 USD per barrel, will fall below the 100 USD per barrel by 2pm due to low consumption by certain industries.
The trader logs into their binary options account and examines the payout percentage for the put option on oil with the 2pm expiration and a strike of 100 USD. The trader finds that the payout will be 170% of their investment if the option expires in-the money, and will lose 80% of their investment if the option expires out-of- the-money.
Confident on the analysis of oil, the trader decides to invest 500 USD in the put option. When expiration occurs at
2pm, oil is trading at 80.25 USD, so the option expires in-the money. The trader receives a return of 170%, or 850USD, on her 500 USD investment.