Binary options only settle at zero or one
Binary options settlement prices
It is a complete fallacy that binary options settlement prices are constrained to zero and one. Certainly, an individual binary call or put will generally settle at zero or one, but even so the option specification might dictate that a binary call or put option settles at 0.5 when the underlying asset price is exactly on a strike at expiry.
As the binary options market matures greater interest will be taken in structured binary strategies that will very often settle at prices between zero and one. The following article points out how immature the current binary options market is and, like the development of the CBOE (and conventional options) illustrates, the binary options market is likely to morph into a far more sophisticated affair with a far greater use of structured binary options.
Binary Options v CBOE
A cursory analysis of the development of the conventional options market shows how only call options were traded initially. A history of the Chicago Board Options Exchange (CBOE) CBOE History shows how the CBOE launched in 1973, yet it was not until 1977 that put options were offered. Prior to put options the full gamut of what are now accepted options strategies could not have existed, e.g. straddles, strangles, combos, put spreads and any other strategy involving puts, but the inclusion of tradable puts was the making of the CBOE. The below photograph illustrates the growth of the CBOE bearing in mind this is the OEX pit; this pit is populated by traders trading options on just one asset, OEX options.
In 1973 the traded conventional options market was in its infancy but only broke free from its shackles in 1977; the binary options market is now in its equivalent years of 1973 to 1977.
Vanillas v Structured Options
As the binary options market develops a greater understanding and acceptance of combinations of binary options will come to pass. In the conventional options market well in excess of 80% of all options quotes are in combinations of call and put options, i.e. less than 20% of business is contracted in vanilla calls and puts. This would suggest that the majority of binary options trades will ultimately be in binary options strategies that have settlement values not only of zero and one but any value in between also.
Binary Option Structures
A couple of examples of this situation could involve:
- a ‘strip’ of two binary call options on an asset with different strike prices but the same expiry. By buying, say, 60 contracts of the upper strike price option and 40 of the lower strike option means that the settlement price could now be 0.0, 0.4 and 1.0, the settlement value of 0.4 being triggered should the underlying asset price settle between the two strike prices. This strategy has been referred to as an Eachway Call.
- an ‘onion option’ is a nest of double no-touch options whereby if the underlying asset price touches neither of the two inner strikes then the onion option settles at 1. But if either of these strikes are touched then the maximum payout would be reduced but not necessarily to zero, say 0.5. This process can be repeated so the new, replacement strikes on being touched reduces the maximum payout yet again, to maybe 0.25. And so on.
An interesting case in point is the Nadex Bull Spread. In conventional options terms this is just a call spread, yet Nadex offer this ‘Bull Spread’ so that there are 100 tradeable underlying prices between and including the two strikes. In effect this is a strip of 100 binary options so already the concept of offering binary options with variable settlement prices has already been firmly established by Nadex.
Markets in Infancy
Financial markets rarely continue in the format that they were originally conceived. This is just as likely to be the case with the burgeoning binary options market as any mature market, most notably the CBOE whom offer a great 25 minute video covering their development.
One of the more obvious changes that will take place in the binary options industry is the acceptance and increased usage of structured binary options; this in turn will spawn a new set of binary options instruments that provide settlement prices bound by the range zero and one yet not constrained to the extremities of zero and one.