What are Binary Options?
In finance, binary options are a specific type of option where the payoff can either be a fixed amount of the asset or just nothing at all. Binary options come in two different types, cash-or-nothing binary option and asset-or-nothing binary option. In a cash-or-nothing binary option, the option pays a fixed amount of money if it expires in-the-money. On the other hand, the asset-or-nothing binary option pays the amount of the underlying security of the option. Thus, both options are binary in nature since there are just two different possible outcomes. These two binary options are also called to as all-or-nothing options, digital options, or fixed return options.
Like a typical vanilla European or American style option, binary options are described by their strike price, maturity date, and underlying reference unit, instrument, commodity or security price. Binary options are sold for a premium payment made upfront, like other options. Calls and puts are both available for binary options.
Binary options are characteristically sold and bought in over the counter markets between different financial hedge funds, institutions, large trading partners, and corporate treasuries. Binary options are highly used when the underlying instrument at hand is a rate, event, commodity, currency, or index.
Binary options can be widely to hedge weather events, like hurricanes, rainfall, or temperature. This is because many transportation and agricultural companies can be heavily affected by the weather conditions. Since the weather is very unpredictable and hard to measure, it makes it the perfect opportunity for binary options since it lets the binary option seller to assume a set amount of risk associated to the happening of a future event that is impossible to predict.
Binary options can also be traded on inflation figures, like the Consumer Price Index or the Producer Price Index in the U.S. These values are reported rather infrequently based on sampling methods done independently, and are typically revised after they are first released once certain input values are further proved. There is no continuing stream of prices since inflation is not actually a traded instrument. Without the continual input prices, it is extremely very difficult to mark-to-market binary options, whose values are strongly dependent on the dense volatility and price data. Binary options allow the buyer to get inflation protection, while at the same time providing the binary option seller with a limited risk in the case where that inflation drops or jumps unexpectedly.
Lastly, binary options are extremely popular in foreign currency markets. Often, emerging market currencies are subject to quick jump risk resulting from economic or political instability, or just due to the comparatively small volume of foreign trade. Cultured currency speculators use low-rate developed economy currencies like the USD or EUR and invest them in high-rate market currencies, and then purchase the binary options as a means of protection against any currency risk. This allows the binary option speculator to earn some profit while protecting being protected from jump risk.