Binary Options - What You Need to Know
Options are notoriously difficult to value given their flexibility, but certain types of options are easier to use than others. Binary options, also known as all-or-nothing options, provide a cash or asset payoff only if certain conditions are met. Given their simplicity, the options have grown increasingly popular over time, moving from over-the-counter to exchange-traded transactions with significant liquidity.
In this article, we’ll take a closer look at how binary options work and when traders should consider using them as an alternative means to profit.
Be sure to also read our guide Options 101: American vs. European vs. Exotic
Binary Options 101
Binary options are essentially “all or nothing” bets that an asset will reach a certain price over a certain period of time. Often times, traders use binary options as a way to speculate on a yes/no event, such as an FDA approval or interest rate decision, in order to avoid the risk of holding a physical position. The options themselves are also growing increasingly popular, which has improved liquidity over time.
For example, suppose that in February a trader believeds that the S&P 500 SPDR ETF will close above $190.00 by the end of May. While the trader could go long SPY or buy a more traditional option, they could instead buy 10 binary call options at a cost of $20.00 a piece or $200.00 in total that pay out $100.00 a piece if the price closes at or above $190.00 level by May.
There are several different types of binary options, including:
- Cash-or-Nothing – The binary option buyer receives a cash payout or nothing at expiration depending on the price at the point of expiration.
- Asset-or-Nothing – The binary option buyer receives the underlying asset as a payout or nothing at expiration depending on the price at expiration.
- Call/Up Option – The trader is buying a binary option in the same way that an options trader is buying a call option on a stock.
- Put/Down Option – The trader is selling a binary option in the same way that an options trader is writing a call option on a stock.
Risk and Rewards
Binary options provide traders with a unique way to profit in many different markets by making all-or-nothing bets, but there are many risks and other considerations that investors should contemplate before buying or selling.
Binary option benefits include:
- Set Risk-Reward Ratio – Traders have a clear idea of the risk versus reward when trading binary options, since the risk is limited to the cost of the option and the reward is limited to the payout of the option.
- No Market Risk – Traders that buy and sell binary options don’t have to worry about market risks like slippage or having their positions stopped out by volatile trading that might occur suddenly or overnight.
- Significant Flexibility – Traders have many different choices when it comes to binary options, which means that they can find solutions that match their needs instead of settling for less-ideal solutions.
Binary option risks include:
- Complete Loss – Traders may lose their entire investment with binary options, which is significantly less likely when purchasing individual stocks or bonds given that few company's go bankrupt.
- Uneven Odds – Traders may find that binary options provide worse odds than purchasing individual options or assuming the risks associated with making outright trades, which makes due diligence very important.
- Liquidity – Binary options aren’t as heavily traded as traditional options, which means that traders may have difficulty buying or selling the options at favorable prices before they are exercised at expiration.
See also the Ten Commandments of Options Trading
Valuing Binary Options
Binary options are valued with the Black-Scholes model, similar to the way traditional stock options are valued. The key difference in valuing binary options is taking volatility skew into account, which can involve a more sophisticated analysis based on call spreads. Since the skew is usually negative, the value of a binary call option is higher when taking the skew into account in valuation.
Binary options are also interesting because they provide additional insights that aren’t available when looking at a stock or plain vanilla options. In finance, stocks have expected returns already priced in and vanilla options provide the market’s estimate of upcoming volatility. Binary options add to that by showing the market’s anticipated skew – that is, patterns that arise in implied volatility.
The Bottom Line
Binary options provide traders with a way to bet on future price direction in an all-or-nothing manner, which provides a very specific risk/reward profile. Traders should carefully weigh the many risks and rewards associated with binary options, including diversification and liquidity concerns. Valuing binary options is similar to plain vanilla options, but must account for volatility skew, which provides interesting insights into the market.
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Quotes of the Day:
- "The stock market is a device for transferring money from the impatient to the patient." - Charles Brandes
- "We like to buy stocks with a long history of profitability." - Walter Schloss
- "Investing is about understanding the risks and rewards of an asset class and making informed decisions based on that understanding." - Edward Lampert
- "The most important thing in investing is to avoid the big mistakes." - Marty Whitman
- "Risk comes from not knowing what you're doing." - Warren Buffett
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