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)
Binary options are usually european style options.
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. This means that an investor can go
long or short on any financial product simply by buying a binary option. Binary
options are offered against a fixed expiry time which may be e.g. 5–30 minutes
in the future, an hour ahead or at the close of the trading day. Binary options
once bought cannot be resold before the expiry time is reached.
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
