Understanding Binary Option from the Put-Call Parity Perspective

5/15/2012

It is never easy to trade especially when taking the option for the first time. This is why you will always need to conduct a comprehensive research on the target niche to grasp all the terms and trading strategies profoundly. Today, if you are thinking of the binary option, the first thing that you must do is understand what the option is all about and how it can be used to your advantage.

When it comes to finance, binary option is simply an option in which the payoff is either a fixed asset amount or nothing. Today, the common types in the option are cash-or-nothing and the asset-or-nothing.

The trade option is referred to as binary simply because there are only two outcomes that can take place at the end of the day; value is paid if option expires or when the underlying security is paid. There are great benefits that you gain from the option. However, if you are using the European options, you should shift your thinking to the option in put-call parity.

Trading options are changing at an exceedingly high speed. Today, put-call parity is the most commonly used binary option in Europe. It defines the relationship of price in European put option and European call option. For the option to work, the market has to be frictionless. This is to mean that there should be no brokers interjecting the process. Unlike the binary option, the underlying in this option must be a liquid asset. If there is no liquidity in assets, the forward contract will suffice.

The assumptions in the put-call parity are minimal. This is unlike the assumptions that have to be made with the Black-Scholes and other financial models. In simple terms, put-call parity basically refers to the relationship of static price in the call and put option on the same instrument. The strike price and expiry date of the two must, however, be the same for the option to work.

When dealing with binary option or the put-call parity, you will come across the word arbitrage. This refers to opportunity to gain profit which results from price variations. In the layman’s terms, if you can buy X and manage to sell it in a different market and make profits, the trade will result in profit. The two markets involved are what affect the profits and risks you make. This is because it is the performance difference of the two markets that affects the price of X.

Put-call parity can be very enterprising for the investor that knows what he is doing. This is because it will offer you with the opportunity to make profits irrespective of the direction the market is heading. The only thing that you need to do is know which side is higher and make your choices accordingly. By so doing, you will elude losses and make profits all year round.

All in all, prior to taking the option, you must note the conditions affecting the trade. First, the binary option has to use the European style. Second, there has to be identical price strike on both the put and call options. There should also be no brokerage or exchange fees of any kind and the interest rates must be constant. No dividends should be paid either.