Digital options

From MarketsWiki

Digital options (also referred to as binary options) are digital calls, digital puts, and digital range options. These are cash-settled options which pay if the option ends up in-the-money, but for which the payout amount is fixed. It does not depend on the amount by which the option ends up in-the-money. For a digital call, the option pays if the final value of the statistic is greater than or equal to the strike price. For a digital put, the option pays if the final value is less than the strike price. For a digital range option, there are two strike prices – a lower one and an upper one – and the holder of the option receives (and the seller pays) the fixed payoff amount if the final value of the statistic ends up greater than or equal to the lower strike, and less than the upper strike. ^[1]

A digital option's payout is characterized as having only two potential values - a fixed payout of, say $1, when the option is in-the-money (underlying price above strike for a call and below strike for a put) or a $0 payout otherwise. The payoff remains the same, no matter how deep in-the-money the option is.

This new type of option is used for the CME Group Hurricane products and many new investors like this new way to offset their hurricane risk. Also, CBOT Binary Options on the Target Fed Funds Rate are binary options because they offer only two outcomes. An event either happens, or it does not; there is no in-between. Accordingly, if a Fed policy move takes place, a binary option pays; if there is no Fed policy move, a binary option makes no payment. This is in sharp contrast to the continuum of payouts offered by conventional options. ^[2]