Binary call options are all-or-nothing options and commonly traded using binary indicators. They are also known as ‘upbets’ and settle at 100 at expiration if they are in the money or zero if they are out of the money.
To understand them, let us have a look at an example. Suppose the underlying is precisely at the strike at expiration. In that case, settlement can occur in several ways: Two obvious possibilities are that binary call options are treated in-the-money or out-of-the-money and settled at 100 or 0, respectively.
A more rational method is to treat the settlement as dead heat and settle the bet at 50. This approach is advantageous when binary call and binary put options are offered with the same strike price since the settlements of the call and put options would add up to 100, while under the first two alternatives, the total settlement would be 200 or zero. Another approach sometimes used when the underlying is settled on the strike is simply canceling all predictions.
The price of binary call options and how to interpret it
The price of binary call options can be interpreted as the probability of the event occurring when the deadweight cost is zero, or in other words, when interest rates are zero. So-called prediction markets using binary call options are sprouting up. They are now widely considered to be a more accurate estimate of the probability of an event occurring than analysts’ forecasts.
How implied volatility affects binary call options
Implied volatility is an essential factor in binary options pricing, and the level of implied volatility determines whether you buy the binary option cheap or too expensive.
For a strike price, as implied volatility increases, so does the option’s value, which is out of the money. This is because when volatility is low, the probability of the strike price rising above the strike price is low, which in turn leads to worthless binary call options. When volatility increases and the underlying fluctuates more, the binary option is more likely to be in the money, which in turn means that the option has a higher chance of winning. Thus, if implied volatility increases the option’s value, it has a positive call vega.
Find more articles in my Binary Options Glossary.