Here at Stock Options Explained we’ve gone to some length to describe stock options basics and the fundamentals of trading stock options. Since most investors trade ordinary ‘vanilla’ options on exchanges such as the CBOE, we have limited our discussion to standard stock options strategies such as buying puts and calls, and selling options, both covered calls and puts. I’d like to give a different type of stock options definition in this article.
Binary options, aka FROs (fixed return options), digital options or all-or-nothing options are a slightly different type of investment vehicle about which investors should be aware, as they provide a way to hedge against or purchase leverage on events that do not easily lend themselves to conventional options trading. The mechanics of binary options trading are very similar to options as you may understand them, but it is interesting and instructive to look at some differences in both types of options.
As you might imagine from the use of the term “binary”, a binary options contract either has a payout for the option buyer or nothing at all, depending on whether it is in the money at expiration or not. So far this sounds similar to conventional options, but the fundamental difference between binary options and standard equity options is that the amount that the option buyer, i.e. the person who is long the option, receives at the expiration date is defined and fixed with binaries, whereas with standard equity options trading the value of the option contract will continue to increase as the underlying stock price continues to move further and further beyond the strike price (i.e. higher in the case of call options and lower in the case of put options).
This description should give you a clue as to the type of occurrences that one uses binary options to invest in or hedge against.
Normally binaries are associated to events that either happen or do not happen, such as weather events, or the results of an election. Trade in binary options will frequently be offered based on the results of statistical data such as inflation figures, which may be reported only periodically (even though in reality they are continuously changing, just as a stock price is), and then either pay a fixed amount if they are ‘in the money’, or represent a total loss if they are ‘out of the money’.
The way in which binary options vary from conventional options notwithstanding, they are fundamentally similar in that the seller usually uses them to hedge against an event in which he is already explicitly or implicitly invested, such that selling the binary option serves to protect his existing position. On the other hand, the buyer uses these options to take a leveraged position on the outcome of an event as usual, with the only difference being that he will profit by some known amount should he be correct in taking the position in the first place.