They’ve been available on the Latest York Stock Exchange (NYSE) only since 2016 but owing to their fixed all-or-nothing payout, binary options (also called digital options) have gotten popular amongst traders and are gaining some interest from individual investors, particularly as a tool for hedging their positions in stocks.
In comparison with the normal plain vanilla put-call options which have a variable payout, binary options have fixed amount payouts, which makes the potential risk and return clear up front.
That will make them seem easy but make no mistake: binary options are an exotic financial instrument and will not be for the faint of heart. The payout really is all or nothing.
Key Takeaways
- Binary options are a kind of exotic options contract with a hard and fast payout if the underlying stock moves past a set threshold or strike price.
- Unlike traditional options contracts, binary options don’t exercise or convert to the underlying shares or other assets.
- Binary options may be used to hedge either long or short positions within the underlying stock. That’s, they may be used to cut back potential stock losses.
Quick Primer to Binary Options
True to the literal meaning of the word “binary,” binary options provide only two possible payoffs: a hard and fast amount ($100) or nothing ($0). To buy a binary option, an option buyer pays the choice seller an amount called the choice premium.
Binary options produce other standard parameters much like those of ordinary 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 client a likelihood 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 instance, if the underlying asset settles above the strike price on the expiry date, the binary call option buyer gets $100 from the choice seller, a net profit of $100 minus the choice premium paid. If the condition is just not met, the choice seller pays nothing and keeps the choice premium as profit.
Binary call options guarantee $100 to the client if the underlying settles above the strike price, while a binary put option guarantees $100 to the client if the underlying settles below the strike price.
In either case, the vendor advantages if the condition is just not met, keeping the choice premium as profit.
With binary options available on common stocks trading on exchanges including the NYSE, stock positions may be efficiently hedged to mitigate loss-making scenarios.
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 complete of $10,500 with a stop-loss limit of $30. Meaning the investor’s maximum loss shall 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 2 can provide the required hedge.
A binary put option may be used to fulfill the hedging requirements of the above-mentioned long stock position.
Assume that a binary put option with a strike price of $35 is obtainable for $0.25. What number of such binary put options should the investor purchase to hedge the long stock position? Here’s 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 * variety of shares = $5 * 300 = $1,500.
- A regular binary option lot has a size of 100 contracts. One needs to buy a minimum of 100 binary option contracts. Since a binary put option is obtainable at $0.25, total cost needed for getting one lot = $0.25 * 100 contracts = $25. This can also be called the choice premium amount.
- Maximum profit available from binary put = maximum option payout – option premium = $100 – $25 = $75.
- Variety 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 evaluation in keeping with different price levels of the underlying, on the time of expiry:
Underlying Price at Expiry |
Profit/Loss from Stock |
Binary Put Payout |
Binary Put Net Payout |
Net Profit/ Loss |
(a) |
(b) = (a – buy price) * quantity |
(c) |
(d) = (c) – binary option premium |
(e) = (b) + (d) |
20.00 |
-4,500.00 |
2,000.00 |
1,500.00 |
-3,000.00 |
25.00 |
-3,000.00 |
2,000.00 |
1,500.00 |
-1,500.00 |
30.00 |
-1,500.00 |
2,000.00 |
1,500.00 |
0.00 |
32.00 |
-900.00 |
2,000.00 |
1,500.00 |
600.00 |
34.99 |
-3.00 |
2,000.00 |
1,500.00 |
1,497.00 |
35.00 |
0.00 |
0.00 |
-500.00 |
-500.00 |
38.00 |
900.00 |
0.00 |
-500.00 |
400.00 |
40.00 |
1,500.00 |
0.00 |
-500.00 |
1,000.00 |
45.00 |
3,000.00 |
0.00 |
-500.00 |
2,500.00 |
50.00 |
4,500.00 |
0.00 |
-500.00 |
4,000.00 |
55.00 |
6,000.00 |
0.00 |
-500.00 |
5,500.00 |
Where,
Stock Buy Price = |
$35 |
Stock Quantity = |
300 |
Binary Option Premium = |
$500 |
Within the absence of the hedge provided by the binary put option, the investor could have suffered a lack of as much as $1,500 on the stop-loss level of $30 (as indicated in column (b)).
By hedging with an additional $500 in binary put options, the loss is restricted to $0 (as indicated in column (e)) on the underlying price level of $30.
A Consideration for Real-Life Trading Scenarios
- Hedging comes at a value. It provides protection from losses but additionally reduces the web profit if the stock is profitable. That is demonstrated by the difference between values in column (b) and column (e), which show (take advantage of stock) and (take advantage of stock + binary put option) respectively. Above the stock profitability scenario (underlying price going above $35), column (b) values are higher than those in column (e).
- Hedging also needs a pre-determined stop-loss level. It is required to calculate the required binary put option quantity for hedging.
- In the instance, the investor must square off the positions if the pre-determined stop-loss level of $30 is hit. If not, the losses will proceed to extend as demonstrated by row 1 and a pair of within the table above, corresponding to underlying price levels of $25 and $20.
- Brokerage charges have to be taken into consideration, as they will significantly impact the hedged position, profit, and loss.
Hedge a Short Stock Position Using Binary Options
For this instance, as an example that the investor is brief on 400 shares of a stock with a selling price of $70. The investor desires to hedge as much as $80, meaning the utmost loss can be ($70 – $80) * 400 = $4,000.
This implies:
- The extent of protection required is the same as the utmost possible acceptable loss per share, which is $80 – $70 = $10.
- The entire dollar value of hedging is the same as the extent of protection * variety of shares, which is $10 * 400 = $4,000.
- Assuming a binary call option with a strike price of $70 is obtainable at an option premium of $0.14, the price to purchase one lot of 100 contracts shall be $14.
- The utmost profit available from binary call = maximum option payout – option premium = $100 – $14 = $86.
- Variety of binary call options required is the same as the entire hedge required/maximum profit per contract, which is $4,000/$86 = 46.511, rounding right down to 46 lots.
- The entire cost for hedging due to this fact is $0.14 * 46 * 100 = $644.
Here is the scenario evaluation in keeping with different price levels of the underlying, on the time of expiry:
Underlying Price at Expiry |
Profit/Loss from Stock |
Binary Call Payout |
Binary Call Net Payout |
Net Profit/ Loss |
(a) |
(b) = (sell price – a) * quantity |
(c) |
(d) = (c) – binary option premium |
(e) = (b) + (d) |
50.00 |
8,000.00 |
0.00 |
-644.00 |
7,356.00 |
55.00 |
6,000.00 |
0.00 |
-644.00 |
5,356.00 |
60.00 |
4,000.00 |
0.00 |
-644.00 |
3,356.00 |
65.00 |
2,000.00 |
0.00 |
-644.00 |
1,356.00 |
70.00 |
0.00 |
0.00 |
-644.00 |
-644.00 |
70.01 |
-4.00 |
4,600.00 |
3,956.00 |
3,952.00 |
75.00 |
-2,000.00 |
4,600.00 |
3,956.00 |
1,956.00 |
80.00 |
-4,000.00 |
4,600.00 |
3,956.00 |
-44.00 |
85.00 |
-6,000.00 |
4,600.00 |
3,956.00 |
-2,044.00 |
90.00 |
-8,000.00 |
4,600.00 |
3,956.00 |
-4,044.00 |
100.00 |
-12,000.00 |
4,600.00 |
3,956.00 |
-8,044.00 |
Where,
Stock Short Sell Price = |
$70 |
Stock Quantity = |
400 |
Binary Option Premium = |
$644 |
Within the absence of hedging, this investor would have suffered a lack of $4,000 on the stop-loss level of $80 (indicated by column (b) value).
By hedging, using binary call options, the loss is restricted to $44 (indicated by column (e) value).
Ideally, this loss must have been zero, as was observed in the instance of binary put hedge example in the primary section. This $44 loss is attributed to the rounding off of the required variety of binary call options. The calculated value was 46.511 lots and was truncated to 46 lots.
The Bottom Line
Plain vanilla call and put options in addition to futures have traditionally been used as hedging tools. Binary options add another tool for the investor looking for to hedge potential losses on heavily-traded stocks.
The examples above, one for hedging long stock positions and one for hedging short positions, illustrate the potential effectiveness of using binary options.
With so many varied instruments to hedge, traders and investors should select the one which suits their needs best on the lowest cost.