What is a Binary-Barrier Option?

A binary-barrier option is a special kind of option. It is a mix between two other types of options: barrier options and binary options. Binary-barrier options are also called American binary options or one-touch options.

When you buy a binary-barrier option, you can get a set amount of cash or assets if the price of something (called the “underlying”) goes past a certain level (called the “barrier”). This can happen at any time before the option expires.

How Binary-Barrier Options Work

Let’s say there is a stock that costs $100 per share right now. You think the stock will go up a lot in price soon. You could buy a binary-barrier option on this stock with a barrier price of $120.

If the stock price touches $120 (or goes past it) even for a moment before the option expires, you get paid right away. The amount you get is set when you buy the option. It could be a fixed dollar amount or a certain number of shares of the stock.

If the stock never reaches $120, you get nothing and lose the money you paid for the option. It doesn’t matter what the stock price is when the option expires. The only thing that matters is if it ever hit the barrier price.

Comparing to Other Options

Binary-barrier options are different from regular (“vanilla”) options in a few ways:

1. Timing of payoff: With binary-barrier options, you can get paid as soon as the barrier is hit. Regular options only pay at expiration.
2. Amount of payoff: Binary-barrier options pay a set amount. Regular options pay based on how much the underlying price is above the strike price.
3. Type of payoff: The payoff for binary-barrier options is always cash or assets. Regular options give you the right to actually buy or sell the underlying at the strike price.

Binary options are similar to binary-barrier options. The main difference is that regular binary options only look at the price of the underlying at expiration. The price before that doesn’t matter. But for binary-barrier options, you get paid if the underlying ever touches the barrier, even if it’s not at that price anymore when the option expires.

Barrier options also have similarities. They have a barrier price that is important, just like binary-barrier options. But regular barrier options don’t have a fixed payoff amount. The payoff depends on the underlying price at expiration compared to the strike price, like vanilla options. They can also be “knock-in” (activated) or “knock-out” (terminated) by touching the barrier.

Why Use Binary-Barrier Options

Binary-barrier options can be used for a few reasons:

1. Speculation: If you have a strong feeling that a stock (or other asset) will move a lot in price soon, binary-barrier options let you make that bet without needing the price to stay high (or low) like regular options.
2. Hedging: Binary-barrier options can protect against big price moves. For example, a company could buy binary-barrier put options on its own stock. If the stock crashes below a key level, the company gets the payoff to offset losses.
3. Income: Some investors sell binary-barrier options to collect the premiums. This can be risky, since a big move against your position means you have to pay out the full fixed amount. But it can provide income if you choose your barriers carefully.

Risks of Binary-Barrier Options

Binary-barrier options have unique risks to consider:

1. Pricing: Binary-barrier options can be harder to price than regular options. The probability of hitting the barrier needs to be estimated. Pricing models for barrier options are often used.
2. Liquidity: The market for binary-barrier options is not always very liquid or active. It can be hard to trade in and out of positions, especially for options on less popular underlying assets. Bid-ask spreads may be wide.
3. All-or-nothing payoff: The payoff structure is risky. If the barrier is barely missed, you lose your whole investment. Regular options would still have some value in that case.
4. Manipulation risk: Since just a brief touch of the barrier level can trigger payoff, binary-barrier options are vulnerable to price manipulation. If someone pushes the underlying to the barrier and then back away, the option buyer profits.

Important Considerations

Before trading binary-barrier options, it’s important to understand them well. Here are some key things to consider:

Regulation and Fraud

Binary options in general have been used for scams and fraud. While binary-barrier options on regulated, exchange-traded markets are safer, some offerings (especially in foreign markets) may be unregulated or even illegal. Be very careful and only trade with trusted, licensed brokers.

Underlying Assets

You can find binary-barrier options on many different things – stocks, currencies, commodities, interest rates, etc. Each market behaves differently. Make sure you are familiar with the underlying you are trading and what can make its price move.

Time to Expiration

The longer your binary-barrier option has until it expires, the more chance there is that the underlying will hit the barrier. But longer-term options usually cost more. You need to balance the timeframe and cost.

Barrier Levels

The choice of barrier level is key. If it’s too far from the current underlying price, it’s unlikely to get hit. Your option will be cheap but have a low probability of paying off. If the barrier is too close to the current price, the option will be expensive and the underlying may not move enough to hit it.

Probability and Expected Value

To decide if a binary-barrier option is a good deal, you need to estimate the probability that the barrier will be hit. Then you can compare the cost of the option to the expected value (probability times payoff amount). This isn’t an exact science, though.

Greeks and Volatility

Regular options have “Greeks” that estimate how their values change with moves in the underlying price, time decay, volatility, etc. Binary-barrier options are also affected by these factors (especially volatility), but the Greeks work differently because of the barrier and fixed payoff features.