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Trending VideosThey have been available on the New York Stock Exchange (NYSE) only since 2016 but owing to their fixed all-or-nothing payout, binary options (also called digital options) are becoming popular among traders and are gaining some interest from individual investors, particularly as a tool for hedging their positions in stocks.
Compared to the traditional plain vanilla put-call options that have a variable payout, binary options have fixed amount payouts, which makes the potential risk and return clear up front.
That may make them seem simple but make no mistake: binary options are an exotic financial instrument and are not for the faint of heart. The payout really is all or nothing.
Key Takeaways
- Binary options are a type of exotic options contract with a fixed payout if the underlying stock moves past a set threshold or strike price.
- Unlike traditional options contracts, binary options do not exercise or convert to the underlying shares or other assets.
- Binary options can be used to hedge either long or short positions in the underlying stock. That is, they can be used to reduce potential stock losses.
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True to the literal meaning of the word "binary," binary options provide only two possible payoffs: a fixed amount ($100) or nothing ($0). To purchase a binary option, an option buyer pays the option seller an amount called the option premium.
Binary options have other standard parameters similar to those of standard options: a strike price, an expiry date, and an underlying stock or index on which the binary option is defined.
Buying the binary option allows the buyer a chance to receive either $100 or nothing, depending on a condition being met. For exchange-traded binary options defined on stocks, the condition is linked to the settlement value of the underlying crossing over the strike price on the expiry date.
For example, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from the option seller, a net profit of $100 minus the option premium paid. If the condition is not met, the option seller pays nothing and keeps the option premium as profit.
Binary call options guarantee $100 to the buyer if the underlying settles above the strike price, while a binary put option guarantees $100 to the buyer if the underlying settles below the strike price.
In either case, the seller benefits if the condition is not met, keeping the option premium as profit.
With binary options available on common stocks trading on exchanges including the NYSE, stock positions can be efficiently hedged to mitigate loss-making scenarios.
How to Hedge a Long Stock Position Using Binary Options
Assume stock ABC, Inc. is trading at $35 per share. An investor purchases 300 shares for a total of $10,500 with a stop-loss limit of $30. That means the investor's maximum loss will be $5 per share.
This long position in stock will incur losses if the stock price declines. But a binary put option will provide a $100 payout if its price declines. Marrying the two can provide the required hedge.
A binary put option can be used to meet the hedging requirements of the above-mentioned long stock position.
Assume that a binary put option with a strike price of $35 is available for $0.25. How many such binary put options should the investor purchase to hedge the long stock position? Here is a step-by-step calculation:
- Level of protection required = maximum possible acceptable loss per share = $35 - $30 = $5.
- Total dollar value of hedging = level of protection * number of shares = $5 * 300 = $1,500.
- A standard binary option lot has a size of 100 contracts. One needs to purchase at least 100 binary option contracts. Since a binary put option is available at $0.25, total cost needed for buying one lot = $0.25 * 100 contracts = $25. This is also called the option premium amount.
- Maximum profit available from binary put = maximum option payout – option premium = $100 - $25 = $75.
- Number of binary put options required = total hedge required/maximum profit per contract = $1,500/$75 = 20.
- Total cost for hedging = $0.25 * 20 * 100 = $500.
Here is the scenario analysis according to the different price levels of the underlying, at the time of expiry:
Underlying Price at Expiry
Profit/Loss from Stock
Binary Put Payout
Binary Put Net Payout
Net Profit/ Loss
(b) = (a - buy price) * quantity
(d) = (c) - binary option premium