Binary Options Explained For The Option Geeks

So lately, there has been a lot of talk about binary options; they are a simple trade, it’s a yes or no, the trader is either right or wrong and it’s winner take all.

Well, that’s some of the story, but what it really boils down to is that binary options are just another option with a few nuances.

How do Binary Options Relate to What Traders Already Know?

First, binary options may also be referred to as Digital Options.

Trading binaries is quite similar to buying a call or buying a put with multiple choices of strikes and durations. One exception with Nadex binary options is that there is no option writer. Nadex binary options are European style and do not have a delivery option. The contracts are exercised only at expiration via a $100 payout per contract and are cash settled.

All binary option contracts are fully collateralized. So on a binary trade, the buyer and seller’s initial trade cost is their maximum risk which totaled is equivalent to the $100 per contract expiration payout. For example, if a binary option trades at 40, the buyer is risking $40, while the seller is risking $60.

Vertical Option Spread Review

In options trading, a vertical spread is an option strategy involving the buying and selling of an option of the same underlying security, same expiration date, but at different strike prices. A vertical spread can be created with either all calls or all puts.

With binary options, the strikes can be compared to a vertical spread but replaced with 0 and 100. For binary buyers, the 100 represents the ceiling and the 0 the floor while the binary pricing is traded between the two levels. For binary sellers, the 100 represents the floor and the 0 the ceiling to the trade.

The binary pricing ranges between 0 and 100 which would be similar to an option premium. The binary price is quoted in dollars per contract compared to the option premium where the cost is the price times a dollar multiplier. Another unique feature of the binary is its pricing is referenced as the delta or probability of the trade. 

With regular options if the underlying is trading at the strike level, the option delta is 50 as is the approximate trade price of the binary (50).

So, if the underlying market is trading above the strike, then the binary pricing will be greater than 50. If the underlying is trading below the strike, then the binary pricing will be less than 50. The binary is a derivative and the pricing, like option premiums, will fluctuate dependent on the usual components of time, volatility and the relation of the strike to the underlying market.

Binary Options / Digital Options

Instead of the variable payout used for the vertical spreads at expiration, the binary payout is for all the marbles.

If the binary traded goes into expiration and has any intrinsic value at all (i.e. the underlying is above the strike) then the contract will settle at 100 in the buyer’s favor and the buyer receives the cash settled $100 per contract.

If the binary traded goes into expiration with no intrinsic value (i.e. the underlying is at or below the strike) then the contract will settle at 0 in the seller’s favor and the seller receives the cash settled $100 per contract.

Note that the expiration values that are used for the settlement process are derived by Nadex, based on the prices of the underlying product. This Nadex calculation uses a sample set of the last 25 futures trades (midpoints for FX) of the underlying right before the expiration time of the binary to arrive at a unique expiration value.

Binary Option Chain

Underlying Market: ESH 1871.00

Time left till Expiration: 2 hours 35 minutes

Binary Buyer Similar to Long CALL

A trader should buy the binary if they want the underlying market to go higher and finish above the strike at expiration to benefit from the full payout at expiration. Traders can also capitalize on the underlying market going higher prior to expiration to take profits from the increased delta in pricing.

As can be seen from the binary option chain, there are binary option strikes that are ITM, ATM and OTM relative to the underlying market at 1871.00.

Example: Buying the US500 (Mar) >1875 at 25 expires in 2 hours 35 minutes

OTM: Cost $25, Net Profit Potential $75 - 300 percent return at expiration (exchange fees not included)

Here, the binary cost would represent all option time value where the underlying needs to rally over four  handles in the 2 hours 35 minutes.

Binary Seller Similar to Long PUT

A trader should sell the binary if they want the underlying market to sell off and finish at or below the strike at expiration to benefit from the full payout at expiration. Traders can also capitalize on the underlying market going lower by taking profits early prior to expiration from the binary pricing trading lower.

Same as before, there are ITM, ATM and OTM binary strikes to choose from but there is not a separate put options chain.  By selling the binary at the trade price, the cost for the seller is 100 minus the binary trade price. So using the same example only selling, the 1875 strike is ITM relative to the underlying at 1871.00 (below the strike level)

Example: Selling the US500 (Mar) >1875 at 25 expires in 2 hours 35 minutes

ITM: Cost $75, Net Profit Potential $25 - 33 percent return at expiration (exchange fees not included)

Here, the binary cost would represent the option’s intrinsic value where the underlying can just sit there, be flat and even trade a little higher as long as it does not finish above the 1875 strike in 2 hours 35 minutes. This binary position would have 4 handles of edge or insurance to receive the $100/contract payout at expiration. For the ITM binary, time decay actually works in its favor.

Note the binary durations available at Nadex are two hours, one day and one week; a binary trade can be initiated and exited at any time prior to expiration.

A useful rule of thumb for binary pricing is that if the underlying is trading at or near the binary strike level, then the pricing should be around 50. At this point, neither the binary buyer nor seller has an immediate advantage.

As for the ITM or OTM binaries with longer durations, the edge is based on a greater differential between the strike price and the underlying price level. This reflects the greater time value associated with the longer duration.  Remember this edge differential is the only variable since the expiration payout for the trade is capped at $100.

Final Thoughts

As the binary expiration nears, the strikes which are ITM for the buyers will be priced very close to 100 and the strikes that are ITM for the sellers will be priced close to 0.  For the binary strike which is ATM as it nears expiration, traders should be forewarned that they could be in for a wild ride. Remember that the binary expiration value only needs to be a fraction of a tick above the strike price for the buyer to receive the $100 payout.  The very nature of the all or none binary valuation results in the contract having a gamma play that can be very explosive.

Futures, options and swaps trading involves risk and may not be appropriate for all investors.