Binary options differ fundamentally from conventional options in the way the option payout is structured. The payout of a binary option depends solely on the outcome of a “yes” or “no” proposition that is related to whether the price of the asset underlying the option is trading above or below a specified level or strike price at expiration. For example, will the S&P 500 be above 2,050 a month from now? Or will the price of gold be below $1,200 two hours from now or at today’s close? Binary options allow a trader to speculate on these outcomes. Binary options are now available on a growing range of equity indices, commodities, currencies, and economic events from firms like Nadex, and even on individual stocks from other firms. However, our focus here is on two binary options currently available from the Chicago Board Options Exchange (CBOE) – which have the S&P 500 and VIX Volatility index as the underlying – and their application to equity markets.

Binary option payout

A buyer of a call binary option will receive a pre-determined fixed payout if the asset price is above the strike price at expiration. But if the asset price is trading below the strike price at expiration, the call binary option expires worthless. Likewise, the buyer of a put binary option receives a fixed payout if the asset price is below the strike price at expiration. If the asset price is trading above the strike price at expiration, the put binary option expires worthless.

This “fixed payout or nothing” feature is what gives the binary option its name. Contrast this with conventional options, where the payout from a call option that is in-the-money depends on how far the price of the underlying asset is above the strike price at expiration. Similarly, for a conventional in-the-money put, the payout depends on how far the price of the underlying asset is below the strike price at expiration.

CBOE’s binary options – BSZ and BVZ

CBOE’s binary option on the S&P 500 index has the ticker symbol BSZ. The price at which this binary option trades reflects the perceived probability that the price of the underlying security (the S&P 500 in this case) will close at or above the selected strike price at expiration for call options, or below the strike price for put options.

Prices of CBOE binary options are quoted in penny increments from one cent to 100 cents ($1) per contract. The higher the perceived probability that the S&P 500 will close at or above a certain level for a call binary option, the higher will be the option price; if the probability is perceived to be 90%, the call will trade at 90 cents. CBOE binary options have a multiplier of $100; i.e. the option price has to be multiplied by $100 to get the price of one contract. Thus, if the option is trading at $0.90, the actual price paid for a contract would be $90.

CBOE’s binary option on the VIX Volatility index has the ticker symbol BVZ. The price at which this binary option trades reflects the perceived probability that the VIX level will be at or above the selected strike price by expiration (for calls), or below the strike price (for puts).

There are very limited expiration months available for BSZ and BVZ, with only three consecutive near-term contract months initially listed for a range of strike prices classified as in the money, at the money or out of money. The exercise style for these options is European, which means that they may be exercised only on the last business day prior to expiration. This means that if the underlying security trades above the strike price prior to expiration, in the case of a binary call, it will not trigger a payout. However, as with conventional options, these binary options may be liquidated (sold or bought to close an opening position) prior to expiration.

How to use BSZ and BVZ

Example 1: Bullish strategy on the S&P 500 using BSZ call

The S&P 500 closed at 2041.32 on November 17, 2014. Your view is that the index may push further into record territory, and based on this bullish view, you buy a January 2050 call binary option (BSZ) which is trading at $0.46 / $0.61. This means that you pay $61 for one call contract.

The following three scenarios arise by the time the option expires on January 17, 2015.

  1. The S&P 500 rises and closes at 2060 on January 16 (the last business day before expiration). In this case, you will receive a payout of $100, for a gain of 63.9%.
  2. The S&P 500 trades lower, closing at 2040 on January 16. In this case, your binary call will expire worthless and you would lose your $61 investment, for a 100% loss.
  3. The S&P 500 closes exactly at 2050 on January 16. In this case, since CBOE binary calls pay out if the settlement value is at or above the strike price, you would receive a payout of $100 for a 63.9% gain.

What if the S&P 500 rises before expiration and is trading at say 2055 by mid-December? While you would be unable to exercise your binary call option as it is a month away from expiration, you can certainly sell it to lock in profits, since the option price would have risen to reflect the higher probability of the S&P 500 closing above the strike price of 2050 by expiration. So if the call is now trading at $0.85, you can sell the contract for $85 to realize a 39% gain.

 

Example 2: Bearish strategy on the S&P 500 using BSZ put

You hold a substantial portfolio of U.S. blue chips and think there is a slight possibility of a correction in the near term. You therefore buy 10 contracts of the January 2000 put binary option (BSZ), which is trading at $0.20 / $0.32. While the December 2000 puts are at $0.15 / $0.27, you prefer the January puts since you are getting an additional month of protection for an extra premium of only 5 cents. You therefore pay $320 as option premium for 10 contracts.

The following three possibilities arise by the time the option expires on January 17, 2015.

  1. The S&P 500 declines and closes at 1990 on January 16 (the last business day before expiration). In this case, you receive a payout of $100 per contract, or $1,000 for 10 contracts, a gain of 212.5%.
  2. The S&P 500 advances marginally and closes at 2045 on January 16. In this case, the puts expire worthless and you would lose your $320 investment, for a 100% loss.
  3. The S&P 500 closes exactly at 2000 on January 16. In this case, the puts would still expire worthless and you would lose your $320 investment for a 100% loss.

 

Example 3: Bearish strategy on the VIX index using BVZ call

The VIX index closed at 13.99 on November 17, 2014. You are an experienced trader who believes market volatility will decline in the weeks ahead. You therefore write five contracts of the December 13 call binary option (BVZ), trading at $0.62 / $0.77, and collect $310 ($62 x 5 contracts) as option premium.

The following three scenarios arise by the time the option expires on December 17, 2014.

  1. The VIX index trades lower and closes at 12 on December 17 (note that the BVZ options expire on a Wednesday). In this case, your binary calls expire worthless, but because you have written the calls rather than buying them, you retain the full $310 premium.
  2. The VIX trades higher and closes at 16 on December 17. In this case, since you are “short” the December 13 calls, you have to pay out $500 ($100 x 5 contracts) for a 61.3% loss.
  3. The VIX bounces around but closes exactly at 13 on December 17. In this case, you are still on the hook for the $500 payout ($100 x 5 contracts) and would incur a 61.3% loss.

 

Pros and cons of binary options

  • Limited outlay: Binary options involve limited outlays and can be used to trade indices, commodities and currencies using small amounts of capital.
  • Limited risk: As with conventional options, the risk to buyers of binary options is restricted to the amount invested. But the limited risk feature is especially advantageous for sellers or writers of binary options, since their maximum risk is $100 even if the trade goes badly awry and the security rises well above the strike price.
  • Suitable for strong views: The all or nothing payout feature of binary options makes them especially suitable for investors who have a very strong opinion on the future direction of a market or security.
  • Attractive return: The all-or-nothing feature of binary options enables the investor to rake in an attractive fixed return even if the option is only slightly in the money.

Binary options have the following drawbacks:

  • Wide bid-ask spreads and lower liquidity:  There is very little open interest in the BSZ and BVZ binary options, which results in much wider bid-ask spreads and lower liquidity than that of standard options.
  • Limited choice: As of November 2014, the CBOE only had binary options on the S&P 500 and VIX (apart from a separate type of product called credit event binary options). Nadex has a much bigger range of binary options, but even so, there is limited choice in binary options compared with the wide range of standard options available.
  • Binary outcome caps upside: Your upside is theoretically unlimited if you have purchased conventional calls and the security subsequently rockets higher. But with a binary call, your upside is limited to $100 per contract even if the security is trading well above the strike price.
  • Unregistered binary option platforms and investor fraud: In June 2013, the SEC warned investors that many Internet-based binary options platforms were not complying with U.S. regulatory requirements and may be operating illegally. The SEC also warned investors about fraudulent practices employed by some binary options platforms, such as refusing to credit customer accounts or reimburse funds to clients, identify theft, and software manipulation to generate losing trades.

The Bottom-Line

While the $100 or $0 payout feature of binary options has some concerned that they are more akin to a gambling product than an investment, their limited reward and limited risk characteristics may appeal to traders with a strong view on a market or security. But those considering binary options trading would be well advised to trade on a regulated U.S. exchange like the CBOE or Nadex, rather than a shady off-shore operator.

Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.

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