So, Two Outcomes Walk Into a Market..

Binary options are making a comeback, but how do they actually work and how do they compare to traditional options trading? In this IBKR Podcast episode, Mat Cashman from the OCC breaks down binary options, fixed payouts, implied probabilities, risk management and why these outcome-based products are attracting renewed interest in today’s markets.

Summary – IBKR Podcasts Ep. 396

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi, everyone. This is Jeff Praissman with Interactive Brokers, and it’s my pleasure to welcome back to the Interactive Brokers Podcast Studio, Mat Cashman from the OCC. Hey, Mat, how are you? 

Mat Cashman

I’m doing great, Jeff. I’m happy to be here again. 

Jeff Praissman

Love having you come in for our podcast. And for our listeners, Mat contributes a ton to our education site between webinars, podcasts, education materials, and of course you can always find him on occ.org as well. So Mat, what are we gonna talk about today? 

Mat Cashman

Today we’re talking about binary options. They are back. It’s an interesting history history lesson, as well as a bit of a survey of what the market structure looks like right now. So I’m excited to talk about them. 

Jeff Praissman

Yeah, there really is a renewed interest, especially in these outcome-based products, right? With the super high growth of short-dated options and of course, prediction market style of trading as well. So with that, let’s get into it. 

Mat Cashman

Yeah. So I think it’s really worth discussing this because these products sit right at the intersection of several things that are happening at the– in the market at the same time. So as you said, we have investors who have become much more comfortable thinking in terms of really specific outcomes. Will the market finish above this level? Will it finish below that level? Can I define my risk around a specific event or a specific time period? And at the same time, we have listed options markets that have already moved heavily toward the shorter duration, like you mentioned. So the growth of the 0DTE index options has kind of trained a lot of people to think about intraday or very short-term outcomes. So binary options take that outcome-based idea and kind of simplify the expiration payout. So instead of asking how far does the underlying move beyond the strike, the binary question is much cleaner. It’s does this underlying finish on the right side of this strike or on the wrong side of this strike, as far as that’s concerned? So that simplicity is useful, but it also creates an educational challenge, which is part of the reason why I’m starting to talk about it. A simple payout doesn’t necessarily mean the product is simple before expiration. That’s always important. You’re still gonna have pricing, probability, time, volatility, liquidity, and settlement mechanics to really understand here, so. 

Jeff Praissman

And a lot of our listeners may think that binary options are new, but the CBOE and the AMEX had versions of these before. Can you, Mat, can you give them a little bit of a history with these? 

Mat Cashman

Sure. Yeah. The Cboe first launched broad-based binaries in 2008 on index products, and the AMEX had something called fixed return options, or FROs. Both of these reflected an early attempt to really bring defined outcome binary stylistic contracts into the US options ecosystem. I was in the SPX at the time trading S&P 500 options, so I remember that period pretty clearly as far as options were concerned. 

The products existed, but they never really became a major part of the listed options ecosystem broadly. I don’t think that necessarily means the concept was flawed. I think the market may not have been ready for it at the time. In 2008, there were a lot of things that were different, right? The retail user experience was completely different. You didn’t have today’s app-based trading environment. The zero commission expectations were not there. API-driven access was different. Zero DTE option obviously didn’t exist at all yet, and the broader prediction market language that has become familiar to a lot of these people trading options wasn’t there. 

So today, the audience is different, the technology is different, the way people discover and interact with markets is different. So this isn’t just a product relaunch story, right? It’s also a story about how much the options market and the retail investor base have changed since 2008. 

Jeff Praissman

And Mat, we should probably take a step back and kind of give a 10,000-foot overview because we kicked off the conversation, we’re talking about binary options, how they’ve kind of existed before. But it probably makes sense to just kind of let the listener know, like, what exactly is a binary option, in case there’s someone out there that may not be familiar with it? 

Mat Cashman

Yeah, it’s a good question and a great place to start. A binary option as you might imagine from its title, is an option with a fixed payout, like a one or a zero kind of vibe. So the fixed payout is based on whether a condition is met at expiration. And in the products that we’re discussing here, the contract pays either a fixed amount or it pays zero. 

So, for example, a binary call might pay 100 bucks if the underlying finishes at or above the strike at expiration because it’s a call, right? And if it doesn’t finish above that strike, it would pay zero. And a binary put would have the exact mirror image of that P&L graph. And so it would pay if the underlying finishes below the strike at expiration, but if it doesn’t, it would pay zero. 

So the big difference here from a standard call or a put is that the binary doesn’t reward magnitude of move beyond the condition being met. If the condition is met, the payout is fixed. If the condition is not met, the payout is zero. So a standard call, the one that you would trade right now before the binaries are being relisted, asks you kind of like how far above the strike did the underlying finish, whereas the binary call is really asking the question, did it finish above the strike, yes or no? And that’s the big distinction between these two types of options. 

Jeff Praissman

Yeah. So in other words, I own this binary call and it’s $10 in the money, I’m still just getting a dollar. 

Mat Cashman

Correct. Correct. It’s a one or a zero outcome, right? That’s why it’s called binary. 

Jeff Praissman

Yeah. And if you could just maybe walk through an example just to kind of, just so we can really spell it out for our listeners. 

Mat Cashman

Absolutely. Let’s give a kind of a simple generic example. Let’s say we have an underlying trading near 600, and there’s a 600 strike binary call that pays 100 bucks if the underlying finishes at or above 600 at expiration. So if that binary call is trading for 42 bucks, the buyer is paying 42 for the possibility of receiving 100 at settlement. 

If the condition is met, the gross profit would be 58 before commissions, fees, and other costs, right? So that’s the 42 bucks you paid for it that you’ve already paid for it, and the thing goes out worth 100. So for the seller, it’s the opposite of that. The seller collects the 42 bucks, but if the condition is met, the seller must pay the $100 settle amount, so the seller’s maximum gross gain is the premium collected, the amount that they sold it for, and the maximum gross loss is the difference between the full payout and the premium collected. So that’s why these products can feel intuitive. The payout is really clearly bounded, right? But bounded doesn’t mean risk-free, and intuitive doesn’t always mean easy. So that’s part of the reason why we’re talking about it now. 

Jeff Praissman

And, so is the price like basically the delta then? If it’s trading at 42, is that really saying that there’s a 42% chance that this is gonna be in the money or is it a little bit more complicated than that? 

Mat Cashman

Yeah, it’s a good way to look at it, and it’s a good way to think about it. And it’s understandable to look at it that way, but it’s also not perfectly precise as far as that’s concerned because the contract pays either 100 or zero. So the price can look like the implied probability, right? At this point in time, if something is trading 42, like in that example we gave, you might look at it and say the market is saying it roughly has a 42% chance of happening, and that’s one way to look at it. But the real market prices are not pure probabilities, right? So there’s a lot built into that. There’s bid-ask spreads, liquidity, the supply and demand dynamic really matters here, time to expiration matters, volatility matters, market maker positioning and hedging costs can also matter. So I would describe the price that you’re looking at as a market implied estimate, not a perfectly clean forecast like coming down from the heavens, right? 

It’s a tradable market price, but it’s not really a promise as to whether or not this thing is gonna pay out. 

Jeff Praissman

So how, in that case then, like how should– Yeah, ’cause these are different, like you said, you come back to that $5 in the money is still only paying a dollar. Like how should investors compare a binary option to the regular call or put that they would be, that they’re used to trading now? 

Mat Cashman

Yeah, it’s good. And I think that question harkens back to what I said at the beginning. The easiest way is to separate direction from magnitude, because a standard call or a put has its value tied to how far the underlying moves beyond the strike, or how far it might also move beyond the strike. And if you own that call and the underlying keeps moving higher, the call can keep gaining intrinsic value all the way, right, to infinity. That’s the whole point of the open-ended part of the optionality. But the binary option is different. It’s focused on whether the condition is met. And so once that condition is met at expiration, payout’s fixed. 

So standard options are about direction plus magnitude, and binary options are really about direction and a threshold being met. So that distinction matters because a binary buyer can be right about direction but not benefit from the additional movement beyond the payout condition. Once the condition is met, the actual barrier of that payout—it pays 100 bucks or whatever that barrier is—that is the payout. It doesn’t pay more because the underlying continues to rally afterwards if it’s a call. So that’s important. 

Jeff Praissman

So with the price and the dollar payout, these are sounding really pretty similar to prediction market contracts in a lot of ways. Is that a fair comparison or am I off mark here? 

Mat Cashman

No, I don’t think you’re off mark. I think it’s a fair comparison. Some of it is because of the environment that we’re in now, and because we have this larger based prediction market environment that people are starting to look at. It’s fair from a user experience standpoint as well, right? But we need to be careful with the structure here. From the user’s perspective, the question can feel very similar: will this market finish above this level, yes or no, right? But from a market structure standpoint, these are listed options. So that means they’re standardized contract terms, they’re exchange listed, they are OCC cleared, there are settlement rules, and option-style pricing dynamics are built into them. And so part of the reason I’m talking about it also is because I think that OCC cleared piece really actually matters in the listed options market. Options Clearing Corporation serves as the central counterparty, which means they become the buyer to every seller and the seller to every buyer. 

That’s a different framework than simply having two market participants meeting each other around some event-style contract. So the interface that people are gonna see may feel very prediction-like, but the product very squarely exists within the listed options framework. And that matters for a lot of reasons, but from my perspective, it matters because there needs to be options education around it. We still have to talk about premium and time to expiration and volatility and settlement and the role of central clearing when we’re talking about these products. They are centrally listed and cleared options. 

Jeff Praissman

Yeah, and that was a great response. And you actually basically just led me into my next question, ’cause I was gonna ask about the Greeks and like, I was supposed to like, how does time affect binary options? 

Mat Cashman

Oh yeah. It’s an interesting thing because like I said, many people are used to trading very short-term options now because of the zero DTE phenomenon that we’ve been talking about forever, and time matters for those options a lot. Time also matters a lot for these binary options because a binary option close to expiration can move very quickly when the underlying is close to the strike. 

You’re talking about whether or not the actual condition is going to be met, right? And if the payout is zero or 100, that’s a huge difference between that being above the strike or below the strike. And so if the underlying is sitting right around the binary strike with only a small amount of time left, a very small move can dramatically affect and change the market price of the binary. 

That’s because the contract is getting very close to its final state. It’s moving toward either the full payout of whatever that is or zero. So this is similar to what we’re already seeing in short-dated options. Risk, in that way, concentrates around strikes and around expirations very specifically, and that’s one of the most important educational points here, I think, is that binary options may be simple at their expiration. Like, when you look backward on them and say, “Was this condition met or was it not?” That looks very simple in retrospect, but they can be really sensitive up to their expiration, especially if we are close to the strike and really close to that expiration. 

Jeff Praissman

So what can binary options… Let’s start with the positive. What can they do well? Like, what are they good for? For lack of a better word. 

Mat Cashman

War, what is it good for? Absolutely nothing!

Jeff Praissman

Yeah exactly. You got me. 

Jeff Praissman

So, I mean, just to kind of recap binary options, I mean, fairly straightforward in a way, right? Like if it’s, if you buy the 50 binary call and the stock closes at 50.01, $50 and 1 cent, you’re gonna make that dollar. And if it closes at $49 and 99 cents it’s worth zero. 

Mat Cashman

Yeah. 

Jeff Praissman

There’s a little twist, right? So not only are there single binary options, but Cboe is introducing quoted dollar-wide vertical spreads, right, alongside these binary options. So what are they about? 

Mat Cashman

Correct. Yeah. So at the same time as Cboe Global Markets, Inc. announced that they were relisting these binary options, they also said that they were going to quote in their COB book, I believe, all of the $1 wide vertical spreads around the at-the-money and around any of these $1 wide vertical spreads that would be relevant to the binary options. I believe it’s on zero day and one day options, are all of those $1 call spreads and put spreads. And this might be the most interesting part of this whole launch, because a tight vertical spread can create a payoff structure that looks very similar to a binary outcome, right? If you think about it, the binary actual outcome looks an awful lot like a $1 call spread or a $1 put spread because it’s bounded at both sides and it has this, like, straight line in between them. 

The only difference is a tight vertical looks similar to that, but has some curvature to it. So imagine that same underlying that we talked about trading 600. Think about the 600, 601 call spread. If the underlying finishes below 600, the call spread’s worth zero. If it finishes above 601, the call spread is worth its full value, which is a full dollar. But if it finishes between 600 and 601, the spread has some amount of partial value, right? It’s like some amount of the distance between those two strikes. And so that’s the big difference between that and the binary. The binary’s all or nothing. The $1 call spreads have that small partial value zone in between the two strikes. So the binary is much cleaner from the payout structure, the fixed payout of zero or one. But the tight vertical spread is more like zero value, partial value in between the strikes, or full value if it settles above the strike for the call spreads or below the strike for the put spreads. And that makes them related, right, but not identical. Interestingly, when we started in ’08, when we started looking at these, our crude way to model them was to think about them like they were call spreads. That’s how we— that’s kind of how we modeled them and thought about them at the time. So it’s interesting. When— that was the first thing that I realized when I read the announcement is like, “Oh, they’re listing all the $1 call spreads and put spreads, too. That’s interesting.” So that’s what’s going on there, and it’s an interesting part of this for sure. 

Jeff Praissman

Yeah, it’s almost like a pseudo-synthetic binary option. 

Mat Cashman

Exactly. Exactly. 

Jeff Praissman

Or the binary option’s like a pseudo-synthetic dollar call spread. 

Mat Cashman

Exactly. Yeah, without the curvature in between, for sure. 

Jeff Praissman

So is comparing them useful then, between the two, even though they’re different? 

Mat Cashman

Yeah, I think it’s useful. It really connects the new… I mean, I— people are calling this a new product. It’s not necessarily a new product, right? It connects it to something that option traders already kind of intuitively understand. If someone understands vertical spreads, then a binary option can be explained as a little bit more of a direct outcome-based structure that looks very similar but has more of a straight line in between the two payouts, right? And so if someone understands the binary payout very well, then you can also tie that to the tight vertical call spread and help them understand the actual listed options that exist already. If they started on the binary side and they wanna learn more about the listed stuff, then that’s interesting, too. 

And from my perspective, it creates this interesting educational bridge between the two where I can help people who understand one to understand the other and vice versa, right? And so I think it also helps investors avoid thinking of binaries as completely separate from options, which I think is important, especially here, because these are part of the options ecosystem, right? They isolate the outcome more directly, but they’re still listed options, and they have all of the, all of the pieces that listed options usually have. 

Jeff Praissman

And we just brought out a whole lot of information and both of us are in the education field. So I think I’m gonna take a step here and just kind of… Let’s just, if you could just point out like what investors, the main risk points that they should really understand about these before they make that decision whether or not to trade or not to trade. But yeah, yeah, but if you just kind of maybe spell it out for them and like, yeah, ’cause we did cover a bunch of stuff here and sometimes it’s just really helpful to kind of sort of just bullet point it basically and point out. 

Mat Cashman

Yeah, for sure. Let’s bullet point this down ’cause there’s a lot there. First, I think just because it’s defined risk doesn’t mean it’s low risk, right? And I talk about that when I talk about defined risk ETFs, right? It’s defined, but it doesn’t mean there’s no risk. It just means the maximum loss you can know in advance, right? The maximum loss or the maximum gain you can know in advance. Second, price is not the same thing necessarily as probability. It may reflect the probability of this happening, but it also reflects some of the other market forces that are out there, namely supply and demand and volatility and all of those things. Third, in this case, being right directionally is not going to necessarily be enough. Now, oftentimes when we talk about options, we talk about that also, right? There’s all kinds of other things going on here. There’s time to expiration, there’s volatility expectations. Those things can change. But in this case, it’s particularly important the settlement condition has to be met at expiration for these to actually pay out or for it to be zero. 

And then fourth, the short-dated contracts can reprice very quickly, just like zero DTE options, especially when you’re close to the strike. That’s something you need to keep in mind, especially if you have a lot of experience trading zero DTE stuff. This stuff is gonna map pretty cleanly to your expectations of time and volatility, but it just has a very, for lack of a better term, it has a very binary payout, right? And so investors need to really understand the full payout before they trade. 

What can I make? What can I lose? What’s the exact condition that has to be met? And when are we measuring that condition? Like, when does this thing expire? When do we figure out whether or not this thing met the condition? If you can’t answer those questions, you probably shouldn’t be jumping in with both feet and trading the product just yet, right? So that’s the distillation of those things to me, I think. 

Jeff Praissman

And earlier in the podcast, Mat, you mentioned back in 2008 when you were in the pit, these things were announced. Does it feel different today? 

Mat Cashman

Yeah. It feels a lot different for a lot of different reasons. 

Jeff Praissman

Yeah. Besides the fact that we’re all almost 20 years older. 

Mat Cashman

I’m a lot older. I’m not standing, like, two feet away spitting on someone while I’m screaming out loud at markets. Yes, things feel different for many different reasons, those two being one of them. But it also feels different, I think, because the customer base is so much different now. In ’08 options were certainly already a very mature marketplace, or they were on the way to being a very mature marketplace. But the retail experience was not nearly what it is today. The average retail investor didn’t have many of the same tools, the same mobile access, the same familiarity with zero DTE, or the same comfort with outcome-based products that they are acquiring as we speak. And so today, I think there’s a lot of investors that are thinking in much shorter timeframes than they used to back then. Partially because there’s just way more ways to express a shorter timeframe opinion based on how short-dated the options are, and they already look at option chains and probabilities and expected moves and defined risk trades. And so the concept of these, I think, is going to land a lot differently now than it did back then. 

But I also think that the education for these has to be better now, too. It’s the product is easier to understand at the surface, but that can be a very good thing, but it can also create overconfidence in people that don’t necessarily understand what they’re doing. So the job of education is to slow people down just enough to understand what the structure means before they trade it. 

Jeff Praissman

Mat, this has been great, but before you leave us what’s the big takeaway? Kind of sum it all up. What is the big takeaway with binary options? 

Mat Cashman

Yeah. So the big takeaways here, and there’s a few of them. The big takeaway at number one, I think, is that binary options may look simple at expiration, but they’re not necessarily simple right up until expiration. They ask a really clean question. That is, does the underlying finish above or below a specific level? But the price of that question is still determined by a market that has bids and offers, and it has supply and demand dynamics just like anything else. That means probability, time, volatility, liquidity, settlement, and clearing all still matter, right? It’s all part of the market. So I wouldn’t think about binary options as replacing standard options. 

They’re not gonna do that. I wouldn’t think about them as anything other than another risk expression tool because that’s kind of what they are and what they were really intended to be originally. And so we’ve just kind of come full circle back to this, but we’re in a different market environment where they might land differently. So standard calls and puts, remember, they have direction and magnitude. Vertical spreads define risk and reward across that range of prices from like that zero to one, and the binary options isolate those specific outcomes. So these are different tools, they’re different structures, they’re different risks. 

And so the closing question for anybody might be: what am I paying for this, how much can I make, and how much can I lose? And what has to happen by expiration for this trade to work and/or not work? And I think those questions you can ask yourself regardless of the structure that you’re looking at. 

Jeff Praissman

Yes. True 

Mat Cashman

I think if you can ask those cleanly and have clear answers to them, I think you’re starting from the right place with these options. 

Jeff Praissman

Oh, Mat, this has been great as always. You can find more from Mat at theocc.com and again, on our website as well under education. Actually really great podcast, Mat. Love having you in here. I always learn something, even though I’ve been in the business for quite a while, but I still always find myself learning something every time we get together and talk shop. So thanks again. 

Mat Cashman

Right on. Thanks for having me. 

Jeff Praissman

All right.