In finance, a binary option is a type of option in
which the payoff can take only two possible outcomes, either some fixed
monetary amount (or a precise predefined quantity or units of some
asset) or nothing at all (in contrast to ordinary financial options that
typically have a continuous spectrum of payoff). 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. 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).[1]
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 $1,000. Then,
if at the future maturity date,
often referred to as an expiry date, the stock is trading above $100,
$1,000 is received. If the stock is trading below $100, no money is
received. Under some contracts if the stock is trading at exactly $100,
the money is returned to the purchaser.
The value of a digital option can be expressed in terms of the
probability of exceeding a certain value, that is, the cumulative
distribution function, which in the Black-Scholes equation is the Gaussian.
Due to the difficulty for market-makers to hedge binary options that
are near the strike price around expiry, these are much less liquid than
vanilla options (that is, standard and ordinary call and put options).
Dealers often replicate them using vertical spreads, which provides a rough, inexact hedge.
Though binary options sometimes trade on regulated exchanges, they are
generally unregulated, trading on the internet, and prone to fraud.[1] The U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have issued a joint warning to American investors regarding unregulated binary options.[2]
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