Binary Option

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Binary Option</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"> <p class="word_list"> <a href="#asset-or-nothing binary">asset-or-nothing binary</a><p class="word_list"> <a href="#binary option">binary option</a><p class="word_list"> <a href="#cash-or-nothing binary">cash-or-nothing binary</a><p class="word_list"> <a href="#digital option">digital option</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body" style="margin-bottom: 24"><strong style="font-weight: 400">A </strong><strong> <a name="binary option">binary option</a></strong><strong style="font-weight: 400"> (also called a </strong><strong><a name="digital option">digital option</a></strong><strong style="font-weight: 400">) is a <a href="../articles/physical%20settlement.htm">cash settled</a> <a href="../articles/option.htm">option</a> that has a discontinuous <a href="../articles/options_spread.htm">payoff</a>. Binary options come in many forms, but the two most basic are: cash-or-nothing and asset-or-nothing. Each can be <a href="../articles/option.htm">European</a> or <a href="../articles/option.htm">American</a> and can be structured as a <a href="../articles/option.htm">put</a> or <a href="../articles/option.htm">call</a>.</strong></p> <p class="body" style="margin-bottom: 24">A European <b><a name="cash-or-nothing binary">cash-or-nothing binary</a></b> pays a fixed amount of money if it expires <a href="../articles/time_value_and_intrinsic_value.htm">in the money</a> and nothing otherwise. For example, a European cash-or-nothing call makes<strong style="font-weight: 400"> a fixed payment if the option expires with the <a href="../articles/derivative_instrument.htm">underlier</a> above the <a href="../articles/option.htm">strike price</a>. It pays nothing if it expires with the underlier equal to or less than the strike price. Exhibit 1 compares the payoff of a European vanilla call with that of a European cash-or-nothing binary call:</strong> </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table6"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Expiration Values for a European <br> Vanilla Call and Cash-or-Nothing Call</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex1_binary_option.gif" width="350" height="142"></td> </tr> <tr> <td> <p class="exhibit_legend">Expiration values for a European vanilla call and a European binary cash-or-nothing call. The cash-or-carry call makes a fixed payment if it expires in the money. It pays nothing if it expires at the money or out of the money.</td> </tr> </table> </center> </div> <p class="body">An American cash-or-nothing binary is issued <a href="../articles/time_value_and_intrinsic_value.htm">out-of-the-money</a> and makes a fixed payment if the underlier value ever reaches the strike. The payment can be made immediately or deferred until the option's expiration date.</p> <p class="body">A European <b><a name="asset-or-nothing binary">asset-or-nothing binary</a></b> pays the value of the underlier (at expiration) if it expires in the money. It pays nothing otherwise. For example, a European asset-or-nothing call pays the value of the underlier at expiration if it exceeds the strike price. A European asset-or-nothing put pays the value of the underlier at expiration if it is less than the strike price.<strong style="font-weight: 400"> Exhibit 2 compares the expiration values of a European vanilla call with that of a European asset-or-nothing binary call:</strong> </p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table7"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">Expiration Values for a European <br> Asset-or-Nothing Put and Call</span><br> <span class="exhibit_subheader">Exhibit 2</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex2_binary_option.gif" width="350" height="142"></td> </tr> <tr> <td> <p class="exhibit_legend">Expiration values for a European asset-or-nothing binary put and call.</td> </tr> </table> </center> </div> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table8"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body" style="margin-top: 24; margin-bottom: 24">An asset-or-nothing binary might be structured as an American option with deferred payment, but this structure is not common.</p> <p class="body" style="margin-top: 24; margin-bottom: 24">Issuers of asset-or-nothing options can construct the instruments by combining a cash-or-nothing binary with a vanilla put or call. A cash-or-nothing binary can be <a href="../articles/dynamic_hedging.htm">dynamically hedged</a>, but issuers sometimes <a href="../articles/hedging_and_diversification.htm">hedge</a> with a <a href="../articles/options_spread.htm">call spread</a> instead. Either approach becomes problematic if the binary is at-the-money as it approaches expiration.</p> <p class="body" style="margin-top: 24; margin-bottom: 24">Pricing formulas for binary options are provided by Reiner and Rubenstein (<a href="#Reiner">1991</a>). See Haug (<a target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm">1997</a>) for an accessible treatment of the same formulas. Taleb (<a target="_blank" href="http://www.riskbook.com/link/taleb_n_(1996).htm">1996</a>) discusses practical issues relating to <a href="../articles/volatility_skew.htm">volatility skew</a>.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table9"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table10"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/asian_option.htm">Asian option</a> An option whose expiration value depends on the average value of an underlier over a specified period.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/barrier_option.htm">barrier option</a> A path-dependent option that terminates or is activated by the underlier reaching some "barrier" level.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">Derivative Instrument</strong></a><strong style="font-weight: 400"> An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.</strong></p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/lookback_option.htm">lookback option</a> </strong> <strong style="FONT-WEIGHT: 400">A path dependent option whose payout depends upon the maximum or minimum underlier value achieved during the entire life of the option.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/option_pricing_theory.htm">option pricing theory</a> The body of financial theory used by financial engineers to value options and other derivative instruments.</strong></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table11"> <tr> <td width="100%"> <p class="explanatory_text">Haug (<a target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm">1997</a>) and Bryis et al (<a target="_blank" href="http://www.riskbook.com/link/briys_et_al_(1998).htm">1998</a>) describes classic pricing methodologies. 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Das (<a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm">2004</a>) provides an in-depth discussion of binaries from a trader's perspective. </p> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap571"> <area target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm" shape="rect" coords="0, 0, 100, 124"> </map> <img border="0" src="../images/book_haug_espen_(1997)_125.gif" usemap="#FPMap571" width="101" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/haug_e_(1997).htm"> <font size="2">Complete Guide to </font><br> Option Pricing Formulas </a></td> </tr> <tr> <td colspan="3"> <p class="author"><b><span class="verdana10bold">Espen G. 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Unscrambling the binary code, <i>Risk</i>, 4 (9), 75-83.</td> </tr> </table> </td> </tr> </table>  <p align="center"><map name="FPMap0_I1"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap0_I1" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm">Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com">http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com">http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 1996 - current</p> <p align="center"><map name="FPMap1_I1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1_I1" width="241" height="89"></p> </td> <td>  </td> </tr> </table> </div> </body>