Wednesday, May 7, 2014

The Difference Between Binary Options & Vanilla Options

The Difference between Binary Options & Vanilla Options

Now, if you haven’t heard by now, there’s a lot of buzz surrounding binary options. The reason is simple, the barrier of entry is low, easy to understand and don’t require you to be staring at the screens all day.

Of course, many people are familiar with US Equity options, however, they are not really sure what binary options are all about.

First, vanilla options are priced using a partial differential equation. The most famous being the Black-Scholes-Merton model. In order to calculate the value of a vanilla option, one must know the options strike price, the price of the underlying asset, the risk-free interest rate, implied volatility and the expiration period. Once you have all these inputs, you plug it into the model and it gives you an estimated value for the option. With that said, there are two prices for a vanilla option, the bid and the ask price.

In reality, the price of an option is what someone is willing to pay for it. The model is just used as an estimate for fair value. To truly understand vanilla options you should understand the theory behind them and the role that probability plays in the model.

On the other hand, binary options are not based on a pricing model. In fact, there is one price, the price of the underlying. In addition, you have two choices, whether you think the asset will trade higher or lower by the expiration period. Not only that, but you don’t have to worry about the role that implied volatility or time decay have like you would if you were trading vanilla options.

Of course, this makes binary options a lot easier to comprehend. However, they do have their drawbacks. For example, with a binary options trade, you’re locked in. This means that you are either going to win a pre-determined fix amount or lose your entire investment. As you might now, vanilla options allow you the ability to get out of a position in order to cut losses or take gains. Also, the profit potential of a vanilla call option is undefined. Whereas with a binary option, the profit is pre-determined before you get in.

In conclusion, binary options are just a simpler product to trade. Although they make sense for the small investor or trader, vanilla options will continue to be the leaders for institutional investors as they offer greater flexibility and profit potential.

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