Abstract
Binary option, also known as digital option, or all or nothing option, is a trading practice that offers discontinuous payoff. Whether or not it pays is determined only by if it reaches a certain price, in other words, whether the option is "in the money" or not. It does not take into account the amount of money.
Forms of Binary Option
There are many forms of binary option. However, two basic forms of binary option are recognized. They are:
- Asset-or-nothing option
- Cash-or-nothing option.
Variations on the Two Basic Forms
- European asset-or-nothing binary option
- European cash-or-nothing binary option
- American asset-or-nothing binary option
- American cash-or-nothing binary option
Barrier Features
The following types of barrier features may be incorporated by binary options:
- Down and In
- Down and Out
- Up and In
- Up and Out
Advantages
The main advantage of binary option is that the buyer as well as the binary option writer is required to determine the direction in which the movement of price is taking place. It does not take into account the magnitude of the option. It is especially useful for the banking sector. For instance, if a bank intends to hedge a particular rate of interest, which is more than a specific level, the bank buys a binary option at a level it intends to hedge. In the event the rate of interest is more than the specific level, the bank is entitled to receive payment, which is fixed irrespective of the increase in the rate.
Salient Features
The payoff profile, which is determined by the changes in price, is discontinuous.
