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A Binary Option ?
option is a type of option where the payoff is either some fixed amount of some asset or
nothing at all. The two main types of binary options are the cash-or-nothing binary option
and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed
amount of cash if the option expires in-the-money while the asset-or-nothing pays the
value of the underlying security. Thus, the options are binary in nature because there are
only two possible outcomes. They are also called all-or-nothing options, digital options
(more common in forex/interest rate markets), and Fixed Return Options (FROs) (on the
American Stock Exchange). Binary options are usually European-style options.
For example, a purchase is made of a binary cash-or-nothing call option on XYZ Corp's
stock struck at $100 with a binary payoff of $1000. Then, if at the future maturity date,
the stock is trading at or above $100, $1000 is received. If its stock is trading below
$100, nothing is received.
In the popular Black-Scholes model, the value of a digital option can be expressed in
terms of the cumulative normal distribution function.
 Non exchange-traded binary options
Binary options contracts have long been available Over-the-counter (OTC), i.e. sold
directly by the issuer to the buyer. They were generally considered "exotic"
instruments and there was no liquid market for trading these instruments between their
issuance and expiration. They were often seen embedded in more complex option contracts.
Since mid-2008 binary options web-sites called binary option trading platforms have been
offering a simplified version of exchange-traded binary options. It is estimated that
around 50 such platforms (including white label products) have been in operation as of
January 2011, offering options on some 70 underlying assets.
 Exchange-traded binary options
In 2007, the Options Clearing Corporation proposed a rule change to allow binary
options, and the Securities and Exchange Commission approved listing cash-or-nothing
binary options in 2008. In May 2008, the American Stock Exchange (Amex) launched
exchange-traded European cash-or-nothing binary options, and the Chicago Board Options
Exchange (CBOE) followed in June 2008. The standardization of binary options allows them
to be exchange-traded with continuous quotations.
Amex offers binary options on some ETFs and a few highly liquid equities such as Citigroup
and Google. Amex calls binary options "Fixed Return Options"; calls are named
"Finish High" and puts are named "Finish Low". To reduce the threat of
market manipulation of single stocks, Amex FROs use a "settlement index" defined
as a volume-weighted average of trades on the expiration day. The American Stock
Exchange and Donato A. Montanaro submitted a patent application for exchange-listed binary
options using a volume-weighted settlement index in 2005.
CBOE offers binary options on the S&P 500 (SPX) and the CBOE Volatility Index
(VIX). The tickers for these are BSZ and BVZ, respectively. CBOE only offers
calls, as binary put options are trivial to create synthetically from binary call options.
BSZ strikes are at 5-point intervals and BVZ strikes are at 1-point intervals. The actual
underlying to BSZ and BVZ are based on the opening prices of index basket members.
Both Amex and CBOE listed options have values between $0 and $1, with a multiplier of 100,
and tick size of $0.01, and are cash settled.
In 2009 Nadex, the North American Derivatives Exchange, launched and now offers a suite of
binary options vehicles.. Nadex binary options are available on a range Stock Index
Futures, Spot Forex, Commodity Futures, and Economic Events.
 Example of a Binary Options Trade
A trader who thinks that the EUR/USD strike price will close at or above 1.2500 at 3:00
p.m. can buy a call option on that outcome. A trader who thinks that the EUR/USD strike
price will close at or below 1.2500 at 3:00 p.m. can buy a put option or sell the
At 2:00 p.m. the EUR/USD spot price is 1.2490. the trader believes this will increase, so
he buys 10 call options for EUR/USD at or above 1.2500 at 3:00 p.m. at a cost of $40 each.
The risk involved in this trade is known. The traders gross profit/loss follows the
all or nothing principle. He can lose all the money he invested, which in this
case is $40 x 10 = $400, or make a gross profit of $100 x 10 = $1000. If the EUR/USD
strike price will close at or above 1.2500 at 3:00 p.m. the trader's net profit will be
the payoff at expiry minus the cost of the option: $1000 - $400 = $600.
The trader can also choose to liquidate (buy or sell to close) his position prior to
expiration, at which point the option value is not guaranteed to be $100. The larger the
gap between the spot price and the strike price, the value of the option decreases, as the
option is less likely to expire in the money.
In this example, at 3:00 p.m. the spot has risen to 1.2505. The option has expired in the
money and the gross payoff is $1000. The trader's net profit is $60
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