Share Market

In the financial world, a binary option is a type of an option where one receives pay off in the form of some fixed compensation if the option expires in the money or nothing if the option contract expires out of the money.

Options are a type of a derivative instrument (an instrument whose value is derived from that of an underlying asset) in the financial world in which one has a right but not the obligation to execute the contract. A call option is the one which conveys the right but not an obligation to buy the contract, while the put option is the one which conveys a right but not an obligation to sell the contract.

In the options lingo, a call option is in the money, when the strike price is less than the market price of the security while it is out of the money when the strike price is greater than the exercise price. A put option is in the money when the strike price is more than the market price of the security and is out of the money when the strike price is less than the market price of the security.

Binary options are of two types, the first one being cash or nothing while the second one being asset or nothing binary option. In the cash or nothing binary option, one pays some fixed amount of cash if the option expires in the money, while in the asset or nothing option, one has to pay the value of the underlying security. Let us understand how the binary option is different from the simple options:

Scenario 1: A simple call options contract –

Suppose X has an understanding with Y to buy 100 shares of company ABC at the end of the month. At the time of the understanding, the company is trading at the price of Rs 50 and X has said that he will buy the shares of the company at Rs 52 (strike price). At the end of the month, if the shares of the company are trading at Rs 67, then X will execute the contract. If otherwise, the shares of the company trade below Rs 52, then the call option will expire worthless.

Scenario 2: A binary option contract –

In this case, suppose, X makes an understanding with Y to purchase binary cash or nothing call option on ABC`s share at a strike price of Rs 100 with a payoff of Rs 500. If then, at a maturity date, the stock is trading above Rs 100; X receives the promised amount of Rs 1,000. If otherwise, the shares of the company are trading below Rs 100, nothing is received.