Exotic Options - Binary Options
This page is part of the Wikinvest Guide to Options. Related articles within this guide include:
Binary Options are options that pay either a fixed amount or nothing depending on whether or not a certain condition is fulfilled when the option expires. This is unlike a regular option whose payoff is dependent on the price of the underlying asset relative to its strike price. For example: A binary option on weather would pay out a fixed amount if the temperature exceeds a threshold.
Binary option are usually structured as European options -- i.e. the holder of the option is only paid if the underlying condition is reached upon maturity. However, there are American styled binary options which are automatically exercised (i.e. pays out) as soon as the price of the underlying asset equals the strike price.
The strike price for binary option is the main determinant of the pay out. For instance, a binary call option on oil with a strike price of $80 and payout of $100,000 would pay the holder $100,000 if the price of oil upon expiration is $80 or more.
Binary options are mainly traded over the counter, however, the CBOE offers binary options on S&P 500 and VIX which traded on an exchange. Option trading websites such as HedgeStreet have also made these options more accessible to retail investors. On the other hand, most casino games and bets with bookies are technically binary options. Many insurance contracts are also designed to be binary options.
There are two popular types of binary options: cash-or-nothing options and asset-or-nothing options. With a cash-or-nothing option the holder is paid a fixed amount of money if the option is in-the-money upon expiration. An asset-or-nothing option pays the holder the value of the underlying asset if the option expires in-the-money.
No touch option enables traders to foretell whether an asset’s price stays above or below a certain level throughout the length of the contract. As soon as the asset’s price hits the specified level, the contract becomes worthless. If it still hasn’t touched that level at expiry, winnings are paid out.
When traders buy a winning contract on Asset or Nothing options, they are given a unit of the asset, instead of a fixed amount of cash. Thus, the price of the asset at expiry determines the trader’s gain. The “asset or nothing” class is typically offered by non-traditional binary options brokers
This option pays out a previously agreed-upon price, as long as the price of the underlying asset is either above or below the strike price of the contract at expiration. The payout price and asset price are completely unrelated, in that winning traders get the same amount of cash whether the price is $1 or $100 into “in-the-money” territory.
One touch binary options are a type of option for traders who believe that the price of an underlying asset will exceed a certain level in the future but who are unsure about the sustainability of the higher price. This options are available to purchase on weekends, when markets are closed.
The Boundary or Range binary options contract works by setting two levels on the contract. One is set 'above' the current market price and one is set 'below'. This contract is similar to the 'tunnel' trade in regular options trading where the payout is made if neither of the specified levels is 'touched' over the duration set on the contract.