A binary option is a
financial exotic option
In finance, an exotic option is an option which has features making it more complex than commonly traded vanilla options. Like the more general exotic derivatives they may have several triggers relating to determination of payoff. An exotic op ...
in which the payoff is either some fixed monetary amount or nothing at all.
[Breeden, D. T., & Litzenberger, R. H. (1978). "Prices of state-contingent claims implicit in option prices". ''Journal of Business'', 621–651.][Gatheral, J. (2006). ''The volatility surface: a practitioner's guide'' (Vol. 357). John Wiley & Sons.] The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The former pays some fixed amount of cash if the option expires
in-the-money
In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a thr ...
while the latter 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
NYSE American, formerly known as the American Stock Exchange (AMEX), and more recently as NYSE MKT, is an American stock exchange situated in New York City. AMEX was previously a mutual organization, owned by its members. Until 1953, it was know ...
).
[Binary Option Definition](_blank)
Investopedia. Retrieved 2013-06-30.
While binary options may be used in theoretical asset pricing, they are prone to
fraud in their applications and hence banned by regulators in many jurisdictions as a form of
gambling
Gambling (also known as betting or gaming) is the wagering of something of value ("the stakes") on a random event with the intent of winning something else of value, where instances of strategy are discounted. Gambling thus requires three el ...
.
Many binary option outlets have been exposed as fraudulent. The U.S.
FBI
The Federal Bureau of Investigation (FBI) is the domestic intelligence and security service of the United States and its principal federal law enforcement agency. Operating under the jurisdiction of the United States Department of Justice, t ...
is investigating binary option scams throughout the world, and the Israeli police have tied the industry to criminal syndicates.
The
European Securities and Markets Authority
The European Securities and Markets Authority (ESMA) is an independent European Union Authority located in Paris.
ESMA replaced the Committee of European Securities Regulators (CESR) on 1 January 2011. It is one of the three new European Sup ...
(ESMA) have banned retail binary options trading.
Australian Securities and Investments Commission (ASIC) considers binary options as a "high-risk" and "unpredictable" investment option, and finally also banned binary options sale to retail investors in 2021.
The FBI estimates that the scammers steal US$10 billion annually worldwide.
The use of the names of famous and respectable people such as
Richard Branson to encourage people to buy fake "investments" is frequent and increasing.
Articles published in ''
The Times of Israel
''The Times of Israel'' is an Israeli multi-language online newspaper that was launched in 2012. It was co-founded by Israeli journalist David Horovitz, who is also the founding editor, and American billionaire investor Seth Klarman. '' newspaper explain the fraud in detail, using the experience of former insiders such as a job-seeker recruited by a fake binary options broker, who was told to "leave
isconscience at the door".
Following an investigation by ''The Times of Israel'',
Israel's cabinet approved a ban on sale of binary options in June 2017, and a law banning the products was approved by the
Knesset
The Knesset ( he, הַכְּנֶסֶת ; "gathering" or "assembly") is the unicameral legislature of Israel. As the supreme state body, the Knesset is sovereign and thus has complete control of the entirety of the Israeli government (with ...
in October 2017.
On January 30, 2018,
Facebook
Facebook is an online social media and social networking service owned by American company Meta Platforms. Founded in 2004 by Mark Zuckerberg with fellow Harvard College students and roommates Eduardo Saverin, Andrew McCollum, Dustin Mosk ...
banned advertisements for binary options trading as well as for
cryptocurrencies and
initial coin offering
An initial coin offering (ICO) or initial currency offering is a type of funding using cryptocurrencies. It is often a form of crowdfunding, although a private ICO which does not seek public investment is also possible. In an ICO, a quantity of cr ...
s (ICOs).
Google
Google LLC () is an American Multinational corporation, multinational technology company focusing on Search Engine, search engine technology, online advertising, cloud computing, software, computer software, quantum computing, e-commerce, ar ...
and
Twitter
Twitter is an online social media and social networking service owned and operated by American company Twitter, Inc., on which users post and interact with 280-character-long messages known as "tweets". Registered users can post, like, and ...
announced similar bans in the following weeks.
Function
Binary options "are based on a simple 'yes' or 'no' proposition: Will an underlying asset be above a certain price at a certain time?"
Traders place wagers as to whether that will or will not happen. If a customer believes the price of an underlying asset will be above a certain price at a set time, the trader buys the binary option, but if he or she believes it will be below that price, they sell the option. In the U.S. exchanges, the price of a binary is always under $100.
Investopedia described the binary options trading process in the U.S. thus:
binary may be trading at $42.50 (bid) and $44.50 (offer) at 1 p.m. If you buy the binary option right then you will pay $44.50, if you decide to sell right then you'll sell at $42.50.
Let's assume you decide to buy at $44.50. If at 1:30 p.m. the price of gold is above $1,250, your option expires and it becomes worth $100. You make a profit of $100 – $44.50 = $55.50 (less fees). This is called being "in the money".
But if the price of gold is below $1,250 at 1:30 p.m., the option expires at $0. Therefore you lose the $44.50 invested. This is called being "out of the money".
The bid and offer fluctuate until the option expires. You can close your position at any time before expiry to lock in a profit or a reduce a loss (compared to letting it expire out of the money).
In the U.S., every binary option settles at $100 or $0, $100 if the bet is correct, 0 if it is not.
In the online binary options industry, where the contracts are sold by a broker to a customer in an
OTC manner, a different option pricing model is used. Brokers sell binary options at a fixed price (e.g., $100) and offer some fixed percentage return in case of in-the-money settlement. Some brokers, also offer a sort of out-of-money reward to a losing customer. For example, with a win reward of 80%, out-of-money reward of 5%, and the option price of $100, two scenarios are possible. In-the-money settlement pays back the option price of $100 and the reward of $80. In case of loss, the option price is not returned but the out-of-money reward of $5 is granted to the customer.
On non-regulated platforms, client money is not necessarily kept in a trust account, as required by government
financial regulation, and transactions are not monitored by third parties in order to ensure fair play.
Binary options are often considered a form of gambling rather than investment because of their negative cumulative payout (the brokers have an edge over the investor) and because they are advertised as requiring little or no knowledge of the markets. Gordon Pape, writing in
Forbes
''Forbes'' () is an American business magazine owned by Integrated Whale Media Investments and the Forbes family. Published eight times a year, it features articles on finance, industry, investing, and marketing topics. ''Forbes'' also r ...
.com in 2010, called binary options websites "gambling sites, pure and simple", and said "this sort of thing can quickly become addictive... no one, no matter how knowledgeable, can consistently predict what a stock or commodity will do within a short time frame".
Pape observed that binary options are poor from a gambling standpoint as well because of the excessive "house edge". One online binary options site paid $71 for each successful $100 trade. "If you lose, you get back $15. Let's say you make 1,000 "trades" and win 545 of them. Your profit is $38,695. But your 455 losses will cost you $38,675. In other words, you must win 54.5% of the time just to break even".
The U.S.
Commodity Futures Trading Commission warns that "some binary options Internet-based trading platforms may overstate the average return on investment by advertising a higher average return on investment than a customer should expect given the payout structure."
Black–Scholes valuation
In the
Black–Scholes model
The Black–Scholes or Black–Scholes–Merton model is a mathematical model for the dynamics of a financial market containing derivative investment instruments. From the parabolic partial differential equation in the model, known as the Black ...
, the price of the option can be found by the formulas below. In fact, the
Black–Scholes formula for the price of a vanilla
call option (or
put option) can be
interpreted by decomposing a call option into an asset-or-nothing call option minus a cash-or-nothing call option, and similarly for a put – the binary options are easier to analyze, and correspond to the two terms in the Black–Scholes formula.
In these, ''S'' is the initial stock price, ''K'' denotes the
strike price
In finance, the strike price (or exercise price) of an option is a fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. The strike price may be set ...
, ''T'' is the time to maturity, ''q'' is the dividend rate, ''r'' is the
risk-free interest rate
The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations.
Since the risk-free ra ...
and
is the
volatility.
denotes the
cumulative distribution function of the
normal distribution
In statistics, a normal distribution or Gaussian distribution is a type of continuous probability distribution for a real-valued random variable. The general form of its probability density function is
:
f(x) = \frac e^
The parameter \mu ...
,
:
and,
:
:
Cash-or-nothing call
This pays out one unit of cash if the spot is above the strike at maturity. Its value now is given by
:
Cash-or-nothing put
This pays out one unit of cash if the spot is below the strike at maturity. Its value now is given by
:
Asset-or-nothing call
This pays out one unit of asset if the spot is above the strike at maturity. Its value now is given by
:
Asset-or-nothing put
This pays out one unit of asset if the spot is below the strike at maturity. Its value now is given by:
:
American style
![American binary put](https://upload.wikimedia.org/wikipedia/commons/7/75/American_binary_put.png)
An
American option In finance, the style or family of an option (finance), option is the class into which the option falls, usually defined by the dates on which the option may be Exercise (options), exercised. The vast majority of options are either European or Amer ...
gives the holder the right to exercise at any point up to and including the expiry time
. That is, denoting by
the strike price, if
(resp.
), the corresponding American binary put (resp. call) is worth exactly one unit. Let
:
The price of a cash-or-nothing American binary put (resp. call) with strike