Binary options or digital options present a plethora of opportunities for traders to make options bets, without have the detriment of extremely high volatility increasing the value of an option to the extent that it becomes too expensive to use as an instrument to use for speculation.  Many traders wonder why not just buy a regular option instead as a way to speculate that are market will be higher or lower over a specific period.   The reasoning is that, in a volatile market, a digital option presents a cheaper alternative to the traditional vanilla option.

Why is this possible?

A Binary option is called binary because it is either in the money or out of the money.  When the payoff comes, it is clear-cut and the amount of money that is paid is fixed.  The definition of binary is “on” or “of” and therefore it is deemed all or nothing.  Binary call option pays out if the underlying or market price exceeds the strike price at expiration. The only difference here is that the payout is a preset amount, regardless of the difference between the market price and the strike price.   A binary Put option pays out the stipulated amount to an option holder only if the market or underlying price is below the strike price.

There is a different to the pricing mechanism used when pricing a binary option relative to a relative pricing a vanilla option.  Vanilla options are priced using a Black Scholes model, which combines the underlying price of the asset, interest rates, the strike price and the current implied volatility.  Implied volatility is one of the most influential inputs and therefore the higher the implied volatility, the higher the price of the vanilla option.

One of the largest differences between vanilla options and binary options is that the binary options payout is fixed.  This means that the difference between the underlying asset and the strike price bears no outcome on the payout if the market is above the strike on a call or below the strike on a put.  For example, a call option on stock that has a strike of $10 with a payout of $1 will make the same payout if the price of the stock is $10.01 or $20.  With this in mind, the value of the option will not increase on a call if the price continues to get higher and higher.  In effect, the binary call option is prices similar to a very tight bull call spread.

A bull call spread is an option structure in which a trader buys a lower priced call, and simultaneously sells a higher priced call.  The payout on a call option bull spread is fixed.  For example, let say a trader purchased a $10 strike for stock ABC and simultaneously sold a $10.10 call for the same stock.  When the price of the stock moves to $10.50 or $11, the payout to the trader is still 10 cents (which is $10.10 – $10.00). The inverse example could be used for displaying a put spread.

The diagram below reflects how a bull call spread will pay off.  As the market moves from below the lower call higher, the payout is zero until the first call strike is reached.  In between strikes, the payoff continues to rise and then levels off once above the higher strike.

The price of the lower prices call will be slightly higher than the price of the higher prices call.  The trader will need to pay a premium for the lower call, but he will receive a premium for the higher priced call.  The two structures will offset each other, with a small outlay when purchasing a bull call spread.  The implied volatility associated with the purchase of the lower priced call will be offset (almost) by the implied volatility of the higher prices call.  The risks associated will be offset for the most part as well.

With this in mind, one can infer that a higher implied volatility will have a limited impact on a call spreads premium.  What also can be inferred is the larger the payout, the more effect implied volatility will have on the premium of the call spread.  Additionally, the skew associated with a call spread might positively or negatively impact the premium associated with a call or put spread.

Since a binary option is priced in a way that is similar to a call spread or a put spread, a trader can infer that when implied volatility is very high, it is more attractive to purchase binary options as a way to speculate on the direction of a market than to purchase vanilla options.  Theoretically, binary options prices should be almost immune to increasing implied volatility.  The larger the payout is relative to the premium, the more it will be affected by changes in implied volatility.