Binary option
Family I · Instruments
Not to be confused with vanilla option, binary trading.
Binary option is a derivative whose payoff is all-or-nothing: the holder receives a fixed cash amount if the underlying price satisfies a stated condition at expiry, and zero if it does not. Because the payout is fixed rather than proportional to the underlying's price, the contract is also called a fixed-return option or digital option. Pricing depends on the probability of the condition being met, not on the size of any subsequent move.
Payoff and pricing
A binary option has two possible outcomes at expiry: a fixed payout or nothing. The premium reflects the market-implied probability of the condition, so a contract that is more likely to finish in the money costs more. The maximum loss is the premium paid; the maximum gain is the payout minus the premium.
Because the payoff is discontinuous, the value of a binary option does not change smoothly as the underlying approaches the strike. Near expiry, small price movements can shift the value sharply between near-zero and near-payout.
Worked example
A cash-settled binary option on an index, with a payout of 100 per contract if the index is at or above the strike at expiry, is quoted at a premium of 40.
The break-even probability is the premium divided by the payout. A buyer profits only if the actual probability of the condition being met exceeds that threshold.
Regulatory treatment
Rules on binary options vary by jurisdiction. Some regulators classify them as financial instruments and permit retail distribution under conduct requirements; others have banned or restricted retail sales, or treat certain contracts as gambling rather than investments. The availability of a product, the maximum payout, and the venues on which it can be traded therefore differ by country and by the legal form of the contract.
Often confused with
- vanilla option
- A vanilla option gives the holder a right to buy or sell the underlying at a strike price, and its payoff rises or falls with the amount by which the option finishes in the money, whereas a binary option pays a fixed amount regardless of how far the condition is exceeded; the visible sign is that a vanilla call's payoff increases with the underlying price above the strike, while a binary's payoff stays flat at the fixed payout.
- binary trading
- Binary trading is a form of speculation in which a contract pays a fixed amount if a stated condition is met at expiry and nothing otherwise, so the payoff has only two possible outcomes rather than a continuous range.