Sunday, November 16, 2014
In finance, a binary option is a type of option in which the payoff can take only two possible outcomes, either some fixed monetary amount of some asset or nothing at all (in contrast to ordinary financial options that typically have a continuous spectrum of payoff). The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security. They are also called all-or-nothing options, digital options (more common in forex/interest rate markets), and fixed return options (FROs) (on the American Stock Exchange).
When buying a binary option the potential return it offers is certain and known before the purchase is made. Binary options can be bought on virtually any financial product and can be bought in both directions of trade either by buying a “Call”/“Up” option or a “Put”/“Down” option. Binary options are offered against a fixed expiry time.
For example, a purchase is made of a binary cash-or-nothing call option on XYZ Corp's stock struck at $100 with a binary payoff of $1,000. Then, if at the future maturity date, the stock is trading at above $100, $1,000 is received. If the stock is trading below $100, no money is received. And if the stock is trading at $100, the money is returned to the purchaser.
The value of a digital option can be expressed in terms of the probability of exceeding a certain value, that is, the cumulative distribution function, which in the Black-Scholes equation is the Gaussian. Due to the difficulty for market-makers to hedge binary options that are near the strike price around expiry, these are much less liquid than vanilla options. Dealers often replicate them using vertical spreads, which provides a rough, inexact hedge.