Binary options are defined in terms of the payout threshold, the date they mature and an underlying reference asset, just like European style option. Just like other options, binary options are sold in exchange for an up-front premium payment and they have. Calls and puts are also available, just like in traditional options.
The only difference between traditional options and binary options is the payout profile. Whereas payoff in a binary option is a fixed amount of money, payoff in traditional options is a potentially unlimited variable amount. Traditional options and binary options are similar in that they can expire worthless, which is referred to as ‘out-of-the-money.’ In binary options, if the underlying asset moves ‘in-the-money’, which means if closes in positive territory, the payoff is a pre-determined amount, no matter by how much the underlying asset closes in-the-money. On the other hand, for traditional options, the payoff would range anywhere from zero dollars to infinity, it all depends on by how much the underlying asset is over the pre-determined price.
Binaries options, which also go by the name digital options, are sold and bought over the counter or OTC in major markets. The trade usually happens between sophisticated financial institutions, corporate treasuries, hedge funds and large trading partners among other similar places. The underlying assets used in digital option trade include commodities, rates, index, events or currencies.
An example of how binary options are used is as a hedge against weather events in the agricultural and transport sectors. This is done by major transport and agricultural companies, which are often affected by severe weather. Since weather is highly unpredictable and it is virtually not measurable, binary options are perfect tools for hedging weather events because it makes it possible for the binary option seller to put up the money in case there is a weather related occurrence in the future. The buyer and the seller usually agree on a respectable and reliable third party to determine whether the event has occurred – in this particular case, government weather bureau in most countries are used. In the United States, digital options trade is also done on inflation figures such as the Consumer and/or Producer Price Index. These figures are reported infrequently and since inflation is not an actual traded instrument, binary options can be used.
Out-of-the-money binary options are cheaper than the equivalent out-of-the-money traditional option. The reason for this is that the digital option has a fixed payout amount in case of an occurrence whereas in traditional options, the payoff can theoretically be infinite and it is only limited by the price of the underlying asset above the pre-determined amount and the credit of the seller. Digital options have a lower ‘time value’ compared to traditional options such as vanilla options.
The trick to be successful with digital options trade is to operate from a range of strength at all time. It is important to reserve capital, meaning you should not risk large options per trade, try multiple opportunities that you suspect will be profitable to spread the risk.
