Binary option | Compendium

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. Thus, the options are binary in nature because there are only two possible outcomes.

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). Binary options are usually European-style options.

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 $1000.
Then, if at the future maturity date, the stock is trading at or above $100, $1000 is received. If its stock is trading below $100, nothing is received.

In the popular Black-Scholes model, the value of a digital option can be expressed in terms of the cumulative normal distribution function.

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In finance, a binary option is a type of option where the payoff is either some fixed amount of some asset 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 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.

Thus, the options are binary in nature because there are only two possible outcomes. 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). Binary options are usually European-style options.

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 $1000. Then, if at the future maturity date, the stock is trading at or above $100, $1000 is received. If its stock is trading below $100, nothing is received.

In the popular Black-Scholes model, the value of a digital option can be expressed in terms of the cumulative normal distribution function. Due to the difficulty in hedging binary options that are ATM near expiry, they are much less traded than vanilla options, but can be approximated with vertical spreads.

Non exchange-traded binary options
Binary options 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.

Since mid-2008 binary options websites called binary option trading platforms have been offering a simplified version of exchange-traded binary options. It is estimated that around 90 such platforms (including white label products) have been in operation as of January 2012, offering options on some 125 underlying assets.

The platforms offer standardized short-term binary options with a pre-determined profit/loss, that cannot be liquidated (buy or sell to close) before expiry.

Business model
The platforms do not charge fees from their investors. Their profit comes from the difference between the options that expire in the money to options that expire out of the money. This difference can be found by the formula below. In this (for each base asset with same expiry characteristics), (W) is the in the money option payout in percentage terms (e.g. 1.7), (L) is the out of the money option payout in percentage terms (e.g. 0.15),

are the turnovers of transactions made for each outcome (e.g $1,000), (S) is the platform's gain.

In this example the platform's turnover is $2,000 and its profit is $150 or 7.5% on turnover. As the platform's gain comes from the above formula, most platforms will be indifferent as to the outcome of a single trade. Note that if

is not equal to

then the platform will have to act as a market maker. This can cause the platform gain (S) to be more volatile than in the above formula. In order for a trader to make a long term profit he has to predict correctly roughly 54.5% of the time (depending on in-the-money and out-of-the money payouts).1(http://en.wikipedia.org/wiki/Binary_option#cite_note-1)

Regulation and compliance
On non-regulated platforms, clients' money is not necessarily kept in a trust account, as required by regulation, and transactions are not monitored by a third party to ensure fair play.

On May 3, 2012, the Cyprus Securities and Exchange Commission (CySEC) announced a policy change regarding the classification of binary options as financial instruments. The effect is that binary options platforms operating in Cyprus (where many of the platforms are based) will have to be CySEC regulated within six months of the date of the announcement. CySEC is the first EU and MiFID-member regulator to treat binary options as financial instruments.3(http://en.wikipedia.org/wiki/Binary_option#cite_note-3)[[4]](http://en.wikipedia.org/wiki/Binary_option#cite_note-4)

Criticism
These platforms may be considered by some as gaming platforms rather than investment platforms5(http://en.wikipedia.org/wiki/Binary_option#cite_note-Forbes-5) because of their negative cumulative payout (they have an edge over the investor) and because they require little or no knowledge of the stock market to trade in. According to Gordon Pape, writing in Forbes:5(http://en.wikipedia.org/wiki/Binary_option#cite_note-Forbes-5)

"If people want to gamble, that's their choice. But let's not confuse that with investing. Binary options are a crapshoot, pure and simple."

Exchange-traded binary options
In 2007, the Options Clearing Corporation proposed a rule change to allow binary options,6(http://en.wikipedia.org/wiki/Binary_option#cite_note-6) and the Securities and Exchange Commission approved listing cash-or-nothing binary options in 2008.7(http://en.wikipedia.org/wiki/Binary_option#cite_note-7) 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.8(http://en.wikipedia.org/wiki/Binary_option#cite_note-8) 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.9(http://en.wikipedia.org/wiki/Binary_option#cite_note-9) The American Stock Exchange and Donato A. Montanaro submitted a patent application for exchange-listed binary options using a volume-weighted settlement index in 2005.10(http://en.wikipedia.org/wiki/Binary_option#cite_note-10)

CBOE offers binary options on the S&P 500 (SPX) and the CBOE Volatility Index (VIX).11(http://en.wikipedia.org/wiki/Binary_option#cite_note-cboebin-11) The tickers for these are BSZ12(http://en.wikipedia.org/wiki/Binary_option#cite_note-12) and BVZ,13(http://en.wikipedia.org/wiki/Binary_option#cite_note-13) 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.11(http://en.wikipedia.org/wiki/Binary_option#cite_note-cboebin-11)[[14]](http://en.wikipedia.org/wiki/Binary_option#cite_note-14)

In 2009 Nadex, the North American Derivatives Exchange, launched and now offers a suite of binary options vehicles.15(http://en.wikipedia.org/wiki/Binary_option#cite_note-15) Nadex binary options are available on a range Stock Index Futures, Spot Forex, Commodity Futures, and Economic Events.

Binary option trading is now an international industry. It is most widely recognized in the United States, but is increasing gaining popularity in the Middle East, Western Europe, Australia and Asia.16(http://en.wikipedia.org/wiki/Binary_option#cite_note-16)

Example of a binary options trade
A trader who thinks that the EUR/USD strike price will close at or above 1.2500 at 3:00 p.m. can buy a call option on that outcome. A trader who thinks that the EUR/USD strike price will close at or below 1.2500 at 3:00 p.m. can buy a put option or sell the contract.

At 2:00 p.m. the EUR/USD spot price is 1.2490. the trader believes this will increase, so he buys 10 call options for EUR/USD at or above 1.2500 at 3:00 p.m. at a cost of $40 each.

The risk involved in this trade is known. The trader's gross profit/loss follows the 'all or nothing' principle. He can lose all the money he invested, which in this case is $40 x 10 = $400, or make a gross profit of $100 x 10 = $1000. If the EUR/USD strike price will close at or above 1.2500 at 3:00 p.m. the trader's net profit will be the payoff at expiry minus the cost of the option: $1000 – $400 = $600.

The trader can also choose to liquidate (buy or sell to close) his position prior to expiration, at which point the option value is not guaranteed to be $100. The larger the gap between the spot price and the strike price, the value of the option decreases, as the option is less likely to expire in the money.

In this example, at 3:00 p.m. the spot has risen to 1.2505. The option has expired in the money and the gross payoff is $1000. The trader's net profit is $600.

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