Where Binary Options are Used

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Binaries are typically bought and sold in the Over the Counter (OTC) markets between sophisticated financial institutions, hedge funds, corporate treasuries, and large trading partners. They are widely used where the underlying instrument is a commodity, currency, rate, event, or index. For example:

Binary call and put options are popular in the platinum market, struck on the mid-market price of the metal of a certain quality, quoted by several dealers over a stated time period. Platinum trades in large varying quantities among major producers and manufacturers, as well as between speculators and dealers. Prices are determined between disparate parties, with varying frequency, and are not centrally reported or confined to a centralized exchange. A third party calculation agent is often agreed upon as part of the deal, to guarantee an uninterested price estimate obtained by sampling various dealers on the expiration date.

Binary options are used widely to hedge weather events, such as hurricanes, temperature, rainfall, etc. Major agricultural and transportation companies can be severely affected by adverse weather conditions. Weather is highly unpredictable and difficult to measure (e.g. what is a hurricane? How fast do the winds have to be? How long does it need to last? Does it need to touch ground or can it remain over water? What must the temperature be? Where is the exact location of the measurement to take place?). This makes a binary option a perfect tool for hedging weather events, as it allows the option seller (option writer) to assume a fixed amount of risk tied to the occurrence of a future event whose magnitude is impossible to predict. An uninvolved and highly reliable third party such as a government weather bureau is typically used to determine whether the weather event has occurred.

Binary options are also traded on inflation figures such as the Consumer Price Index (CPI) or Producer Price Index (PPI) in the U.S. These figures are reported fairly infrequently based on independent sampling methods, and are often revised after they are released once input values are further verified. There is no continual stream of prices because inflation is not an actual traded instrument (aside from recent developments in exchange-traded inflation futures). Without continual input prices, it is very difficult to mark-to-market vanilla American or European options, whose value is highly dependent on dense volatility and price data. A binary option allows the buyer to obtain inflation protection, while providing the option seller with limited risk in the event that inflation jumps or drops unexpectedly.

Finally, binary options are popular in the foreign currency markets, especially on illiquid and volatile currencies such as the Turkish Lira and Thai Bhat. Emerging market currencies are often subject to rapid "jump risk" caused by political or economic instability, or simply illiquidity due to the relatively small volume of foreign trade. Sophisticated currency speculators borrow low-rate developed economy currencies such as USD or EUR and invest in high-rate emerging market currencies, then purchase binary options as protection against currency risk in the high rate leg. This allows the speculator to earn "carry" while protecting against "jump risk."