Definition
A binary option is a financial option in which the payoff is either some fixed monetary amount or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The former pays some fixed amount of cash if the option expires in-the-money while the latter pays the value of the underlying security. They are also called all-or-nothing options, digital options, and fixed return options.
Binary Option
A binary option is simply a ‘yes’ or ‘no’ settlement between two people, and involves a certain asset and a particular (short) time period. To better grasp the concept of binary options, you must understand the following terms.
Time frame
Just like most dealings in the stock-market, binary options are also bound by a certain time period. Only that this case involves a fairly short period. It could be anywhere from a few hours to a week. This time-frame is specified down to the exact minute of the deadline.
Strike price
The strike price is basically a base-price that settles a binary option. It is based on the current market price of the asset. On the basis of this current market price of the asset, a future price is determined by the buyer.
Cost of binary option
The cost of buying a binary option from a seller always remains between $0 and $100. It is often considered as a probability of hitting the strike price. For instance, if the probability of hitting the strike price is 0.3, the cost of buying the option becomes $30. However, it could be anywhere between zero to hundred regardless of any probability.
How does a binary option work?
In a binary option, the buyer determines the near-future price of a certain asset. This predicted future price is called the strike price of the option. If the asset has a fifty percent chance of hitting the strike price, the seller will charge $50 for the option. At the same time, a time-frame or expiry time (deadline) of binary option is also set. If at the time of expiry, the asset goes over the strike price, the buyer gets a $100 (always fixed) for every binary option bought. If the strike price is not met, the seller gets $100 per option.
Example:
- Price of an asset: $15
- Strike price set at 12:00 pm: 15.20
- Deadline: 02:00 pm
- Buyer’s bid for the option: $10
- Seller’s bid for the option: $12
Let us suppose the binary option is sold for $11. If at 02:00 (deadline), the price of the asset is $15.21 (basically anything above $15.20), the buyer gets $100, and the seller goes empty handed.
If the strike price is not hit, which means that the price of the asset at 02:00 pm is $15.19 or anything less than that, the seller gets the $100 while the buyer goes empty handed.
The binary option does not exercise any right over the possession of the asset itself.
Further Reading
- Numerical Solution for Binary Option Following Constant Elasticity of Variance Model [J] – en.cnki.com.cn [PDF]
- Empirical case study of binary options trading: An interdisciplinary application of telecommunications methodology to financial economics – www.igi-global.com [PDF]
- Fuzzy pricing of binary option based on the long memory property of financial markets – content.iospress.com [PDF]
- Fractional white noise calculus and applications to finance – www.worldscientific.com [PDF]
- Binary option pricing model with transaction costs and the payment of dividend [J] – en.cnki.com.cn [PDF]
- A binary option pricing based on fuzziness – www.worldscientific.com [PDF]
- Binary Options as New Financial Instruments and Their Integration into the Financial Sector – www.atlantis-press.com [PDF]
