Binary Option Pricing Dynamics - Moving From Out of the Money Into the Money

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Binary Option Pricing Dynamics - Moving From Out of the Money Into the Money

In general, an out of the money binary option will be cheaper to purchase than an equivalent out of the money vanilla option, assuming the same underlying, strike, and time to expiration. This is because the binary option has a fixed payout in the event it expires in the money. The vanilla option, on the other hand, can theoretically pay an infinite amount, limited only by the potential underlying price and credit of the option seller. Out of the money vanilla options typically have greater "time value" than binary options.

This valuation difference between an out of the money binary and vanilla option has two benefits. First, it enables the option seller to assume a known limited risk. Second, from the perspective of the buyer, a binary option can offer significantly greater leverage since the up front premium investment is lower.

When a binary option moves from being out of the money to in the money, its theoretical value profile is much different than a vanilla option. The binary option moves up in value very rapidly as it crosses the strike threshold. For example, with a strike of $50 and a fixed payout of $5, a binary call option will move very quickly from $2.50 to $4.00 or more just as it crosses the $50 strike level. This is because a move above $50 by any amount (even one-half cent) guarantees a $5 payout. The resulting profile is a "bulge" or "step". Conversely, when a binary option moves from in the money to out of the money, its value changes very quickly, dropping towards zero in a steep fall, then leveling off.