What Are Binary Options?

There are two primary types of binary options available: cash-or-nothing and asset-or-nothing options. Both types of options provide a fixed payout amount to the owner in the event that a certain condition is met prior to expiration. Binary options are also known as all-or-nothing options. This is different from traditional options which pay a proportional amount based on the distance between the option's strike price and the market price of underlying security at expiration. For this reason, most binary options trade as European-style options, meaning that they are only exercised at the expiration date.

The Mechanics of a Binary Option

Binary options are either cash-or-nothing or asset-or-nothing options. At expiration, if the option is in-the-money, these options pay either a set cash amount, or a set amount of an underlying asset. In some cases, asset-or-nothing options are settled for the cash value of the asset described by the option. If a binary option is not in-the-money, it will expire worthless. In-the-money means that the price of the underlying security is above the strike price of a call or below the strike price of a put at expiration. These instruments are similar to digital options which trade primarily in the foreign exchange market.

For example, if you were to buy a cash-or-nothing binary option on ABC stock with a strike price of $50 and a payout amount of $250, if the stock were trading at or above $50 at the expiration date of the option, you would receive $250; if the stock was trading below $50, you would receive nothing. With a traditional option, if the stock were trading at $51, you would receive $100. If the stock were at $52.50, you would receive $250. The amount received with a traditional option is relative to more factors. The higher the stock price, the higher the payout. With a binary option, the payout is fixed.

One of the reasons that these options have gained in popularity is that they are often easier to price than traditional American-style options. Binary options can be easily priced using one of the popular options pricing models, such as Black-Scholes. American options have a greater degree of variability because of the possibility of early exercise.

Liquidity and Availability

While binary options were once traded as exotic options, exchange-traded binary options became available on both the American Stock Exchange and the Chicago Board Options Exchange (CBOE). The most popular types of binary options are those that trade with the S&P 500 or the CBOE Volatility Index (the VIX) as their respective underlying securities.

The binary options that trade on the AMEX are derivatives of certain ETFs and some of the most liquid equity securities. These instruments give traders an additional tool with which to cover their market bets, although they have different levels of risk than ordinary options.

In general, while it is a good idea to know about alternate types of options, you should limit your trading of them to small positions until you become more familiar with their peculiarities. Where you can benefit from binary options is in learning about complex pricing models, because of how easily they lend themselves to this type of use.