With everything being equal, generally, out of the money binary options are cheaper to buy than traditional out of the money options. This is due to the fact that the payouts for binary options are fixed when they expire in the money. Traditional options on the other hand, theoretically have an infinite payout amount. They also normally have greater “time value” than that of binary options.
This valuation difference between traditional out of the money options and binary options allow for:
* The assumption of a quantifiable risk by the option seller.
* For the buyer, he is able to obtain greater leverage for his capital as the premium investment is much lower.
However, as a binary option moves from an out of the money position to in the money position, its valuation profile will become different from that of a traditional option. The value of an in the money binary option will increase rapidly as it move across the strike price threshold. This is due to the fact that any move across the strike price threshold guarantees the payment of the predetermined fixed payout.
On the other hand, when binary options move from being in the money to out of the money position, its value will also drop rapidly toward zero. If the above scenarios are represented graphically, the resulting profile will look like a “step” profile.
In contrast, the value profiles of traditional options when they move from an in the money position to an out of the money position changes more subtly. Its graph will look more like a curved line rather than a “step” line. For example, let say the strike price of a traditional call option is $50. As the underlying value of the asset increases, the value of the option will also increase albeit gradually as it approaches the strike price threshold of $50. Likewise when a traditional call option moves from being in the money to an out of the money position, its value will drop gradually as well.
Volatility Dynamics of Binary Options As Compared To Traditional Options
Generally, binary options are more sensitive to the fluctuations of the underlying assets as compared to traditional options. Nevertheless, the extent of the sensitivity will depend on whether the underlying price is:
1. 1. Deep in the Money
2. 2. Deep out of the Money
3. 3. Or near the Money
For both traditional options and binary options, while the underlying assert is far from reaching the strike price, they are both less volatile. Nevertheless, with traditional options, when out of the money, they are more sensitive to actual and perceived volatility of the underlying assets. This sensitivity becomes an even larger factor in the value of the traditional options when the price of the underlying moves nearer to the strike price threshold.
With binary options values however, when the underlying price approaches and cross the strike price threshold, its value becomes very sensitive to volatility. Its value is essentially spiked. And as with traditional options, the value of binary options becomes less sensitive once it moves deep into the money.