Archive for July, 2009
SYSTEM AND METHODS FOR TRADING BINARY OPTIONS ON AN EXCHANGE
Posted by admin in Binary Options, Bungee Options on July 27th, 2009
The invention relates to financial systems and methods for trading fixed return options on secondary markets such as stock exchanges. A financial system of the invention includes both an electronic order delivery and execution system and/or an on-floor trading auction, configured to provide an exchange-traded environment. The financial system also includes at least one fixed return option or binary option traded through an exchange’s order delivery and execution system or on-floor trading auction, whereby such trading environment provides an open market. The system of the invention makes the trading of fixed return options or binary options possible via a unique use of the existing symbology schemes for standardized (non-binary) options, such that “Finish High” options are processed as calls, and “Finish Low” options are processed as puts, enabling these newly standardized binary options to be both recognized and accepted as standardized option contracts by existing trading, clearance, margin and settlement systems, while also enabling these options to be differentiated from additional standardized options, and appropriately segregated for different treatment than the typical standardized option forms. The system employs a novel method for calculating the closing settlement value for securities underlying fixed return options or binary options in order to maintain a fair and orderly trading environment for these instruments on an organized exchange
CBOE to list binary options on S&P and VIX
Posted by admin in Binary Options, Bungee Options on July 27th, 2009
CBOE binary options contracts, on which calls will be listed first, pay either a fixed cash settlement amount if the underlying index settles at or above the strike price at expiration, or nothing at all if the underlying index settles below the strike price at expiration.
The products are expected to attract a broad range of participants, including individual investors, hedge funds and institutions, who have an opinion, one way or another, on future price movements in the SPX or the VIX, said CBOE chairman and Chief Executive William Brodsky in a statement.
Through May, volume in SPX options rose to nearly 65 million contracts. Options on VIX, often called Wall Street’s fear gauge, totaled more than 10 million contracts. Both SPX and VIX notched record volume for the 2008 five-month period, CBOE said
SECURITIES AND EXCHANGE COMMISSION – Binary/Bungee Options Rules
Posted by admin in Binary Options on July 27th, 2009
Self-Regulatory Organizations; The Options Clearing Corporation; Notice of Filing of a Proposed Rule Change Relating to Binary Options
Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (”Act”),1 notice is hereby given that on June 28, 2007, The Options Clearing Corporation (“OCC”) filed with the Securities and Exchange Commission (”Commission”) the proposed rule change as described in Items I, II, and III below, which items have been prepared primarily by OCC. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.
I. Self-Regulatory Organization’s Statement of the Terms of Substance of the Proposed Rule Change
The proposed rule change would amend OCC’s By-Laws and Rules to permit OCC to clear and settle various types of binary options, including “fixed return options” to be listed by the American Stock Exchange (“Amex”) and binary options on broad-based securities indexes proposed to be listed by the Chicago Board Options Exchange (“CBOE”).
II. Self-Regulatory Organization’s Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change
In its filing with the Commission, OCC included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. OCC has prepared summaries, set forth in sections (A), (B), and (C) below, of the most significant aspects of such statements
The purpose of the proposed rule change is to permit OCC to clear and settle binary options, including fixed return options (“FROs”) to be listed and traded by Amex3 and binary options on broad-based indexes proposed to be listed and traded by CBOE.4 Binary options (sometimes referred to as “digital” options) are all-or-nothing options that pay a fixed amount if exercised in the money and otherwise pay nothing. Until recently, OCC did not clear any binary options other than credit default options (“CDOs”) traded on CBOE. CBOE and OCC recently were granted approval for CBOE to trade and for OCC to clear related products called credit default basket options (“CDBOs”).5 General characteristics of binary options, excluding features unique to CDOs and/or CDBOs that were already described in OCC’s prior rule changes, are described below, followed by an explanation of the specific rule changes being proposed by OCC.
Description of Binary Options. Binary options are cash-settled options that have only two possible payoff outcomes, either a fixed exercise settlement amount or nothing at all. They are subject to automatic exercise. The underlying interest of a binary option may be one or more securities, an index of securities, or some other measure; however, OCC presently intends to clear only binary options that are within the definition of a “security” as determined by the Commission. In its capacity as a “derivatives clearing organization” regulated by the Commodity Futures Trading Commission (“CFTC”), OCC may in the future propose to clear binary options that are commodity options subject to the jurisdiction of the CFTC.
A binary option, other than a CDO or CDBO, is in the money and will be automatically exercised if its underlying interest value, when measured against its exercise price, is determined to meet the criteria for automatic exercise as specified in the Exchange Rules of the listing Exchange.6 For example, in the case of a “finish high fixed return option,” such option will be automatically exercised and settled for a fixed amount of cash if its underlying interest value is above its exercise price at expiration. In the case of a “finish low fixed return option,” such option will be automatically exercised and settled for a fixed amount of cash if its underlying interest value is below its exercise price at expiration. The rules proposed in this current filing for binary options are intended to be sufficiently generic to be the basis for clearing binary options proposed to be listed by Amex and CBOE as well as other binary options in the future.
By-Law and Rule Amendments Applicable to Binary Options. In order to provide a framework of rules that can accommodate clearance and settlement of various kinds of binary option products, OCC proposes to broaden the By-Law Article and Rule Chapter covering CDOs and CDBOs.
(1) Terminology—Article I, Section 1 and Article XIV, Section 1
“Binary option” would be defined in Article XIV, Section 1 of the By-Laws, and the definition would be cross-referenced in Article I of the By-Laws.
The definitions of “option contract” and “type of option” in Article I of the By-Laws would be amended to include a binary option.
OCC proposes to redefine the term “class” in Article XIV, Section 1 so that it will apply to binary options generally. To be within the same class, binary options other than CDOs or CDBOs must cover the same underlying interest and have otherwise identical terms except for exercise price (if any) and expiration date.
The definition of “exercise price” in Article I would be replaced with respect to binary options with a revised definition in Article XIV, Section 1 which would recognize that binary options will be settled by a fixed cash payment. The exercise price of a binary option is neither an amount that is paid in exchange for an underlying interest nor is it used to determine the exercise settlement amount as in the case of other cash-settled options. In the case of a binary option other than a CDO or CDBO, the exercise price of a binary option is simply a defined value or range of values for the underlying interest. If the underlying interest value falls within the defined range at expiration of such binary option, the option will be automatically exercised; otherwise, the option will expire unexercised. A CDO or CDBO is said to have no exercise price.
OCC proposes to redefine the term “underlying interest” in Article XIV, Section 1 so that it will apply to binary options generally. In the case of a binary option other than a CDO or CDBO, the underlying interest is the underlying security, securities, index, basket, or measure whose value is compared to such option’s exercise price to determine whether the option is in the money and will be automatically exercised. In conjunction with the revised definitions of “exercise price” and “underlying interest,” OCC also proposes to add a new defined term, “underlying interest value,” to Article XIV, Section 1. When used with respect to a binary option other than a CDO or CDBO, underlying interest value means the value or level of the unit of trading of the underlying interest at any point in time as reported by the reporting authority. A new definition for the term
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“unit of trading” would state “unit of trading” when used with respect to a binary option means the quantity of the underlying interest on which the underlying interest value is based and is ordinarily a single share in the case of binary options on individual equity securities or one (1) in the case of binary index options. The terms “unit of trading” and “underlying interest value” would not be applicable to CDOs and CDBOs.
Other terms that were created or amended for CDOs and CDBOs will be modified to apply to binary options generally.
(2) Terms of Cleared Contracts—Article VI, Section 10(e)
Paragraph (e) of Article VI, Section 10 would be further amended to apply to binary options generally.
(3) General Rights and Obligations—Article XIV, Section 2B
Article XIV, Section 2B would define the general rights and obligations of holders and writers of binary options other than CDOs or CDBOs. As noted above, the holder of a binary option that is automatically exercised would have the right to receive the fixed exercise settlement amount from OCC, and the assigned writer would have the obligation to pay that amount to OCC.
(4) Adjustments of Binary Options Other than CDOs or CDBOs—Article XIV, Section 3A; Unavailability or Inaccuracy of Final Underlying Interest Value—Article XIV, Section 5; Determination of Final Underlying Interest Value—Article XIV, Section 6
Article XIV, Section 3A would describe the methods by which binary options other than CDOs or CDBOs generally will be adjusted if adjustments are deemed to be necessary. Special adjustment rules are needed because of the fixed, cash-settlement feature of binary options. For instance, under Article VI, Section 11A(d), which governs adjustment of other equity options, if there is a stock dividend, distribution, or split
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whereby a whole number of shares of the underlying security is issued for each outstanding share, the exercise price is proportionately reduced, and the number of option contracts is increased by the number of shares issued with respect to each share of the underlying security. This adjustment would be inappropriate for binary options for which the underlying interest is an equity security. For example, an XYZ option with an exercise price of $50 would be adjusted to become two XYZ options, each with an exercise price of $25. Because the fixed exercise settlement amount of a binary option is intended to remain at $100, this adjustment would increase the total payout upon exercise to $200. To avoid this result, Article XIV, Section 3A(a)(4) would provide that the number of option contracts would not proportionally increase and only the exercise price would be adjusted. The other provisions of Article XIV, Section 3A are similar to Article VI, Section 11A, with appropriate modifications for binary options. In order to maintain consistency with adjustment policies for physically settled stock options where such consistency is appropriate, certain changes in the treatment of dividends that were proposed in SR-OCC-2006-01 to become effective at a future date, will become effective on the same date for binary options on single stocks.
Article XIV, Section 3A(b) would govern adjustments of binary options for which the underlying interest is an index of equity securities and would be similar to Article XVII, Section 3, which governs index options, with appropriate modifications to reflect unique features of binary options. For instance, because binary options do not have an index multiplier, the Securities Committee would generally adjust the exercise price of a binary option of which the underlying interest is an index of equity securities to get the appropriate result.
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Article XIV, Section 5, would give OCC the authority to fix the underlying interest value for a binary option other than a CDO or CDBO and to rely on that value for determining whether such binary option would be exercised under circumstances similar to those in which OCC may currently fix the exercise settlement amount for index options.
Article XIV, Section 6 would provide, in essence, that the underlying interest value of a series of binary options at expiration, other than CDOs or CDBOs, would be determined by the Exchange or Exchanges on which such series is traded subject to any overriding provision of OCC’s By-Laws and Rules. If a series of options is traded on more than one Exchange, OCC could use the underlying interest value received from the Exchange deemed by OCC to be the principal Exchange, or OCC could employ a procedure to derive a single value based on some or all of the values received.
(5) Exercise and Settlement—Chapter XV of the Rules and Rule 801
Binary options would not be subject to the exercise-by-exception procedures applicable to most other options under OCC’s Rules but would instead be automatically exercised prior to or at expiration if the specified criterion for exercise is met. The procedures for the automatic exercise of binary options, as well as assignment and settlement of exercises (including provisions applicable to a suspended Clearing Member), would be set forth in Rules 1501 through 1505 of new Chapter XV and in revised Rule 801(b).
(6) Margin Requirements—Rule 601; Deposits in Lieu of Margin—Rule 1506
OCC would margin binary options through its usual “STANS” system. STANS has been modified to accommodate the particular binary options to be traded by Amex
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and the binary index product currently proposed by CBOE. CDOs and CDBOs will be margined as described in the applicable rule filings cited above.
OCC is not proposing to accept escrow deposits in lieu of clearing margin for binary options. Therefore, Rule 1506 would state that Rule 610, which otherwise would permit such deposits, does not apply to binary options.
(7) Acceleration of Expiration Date—Rule 1507(d)
This new provision would accelerate the expiration date of a binary option other than a CDO or CDBO when OCC determines in its discretion that the underlying interest value of such option has become fixed prior to the expiration of the option (e.g., where the equity security underlying a binary option has been converted by a merger into the right to receive a fixed amount of cash). If the option is out of the money, it would expire unexercised. Otherwise, it would be automatically exercised.
The proposed changes to OCC’s By-Laws and Rules are consistent with the purposes and requirements of Section 17A of the Act because they are designed to promote the prompt and accurate clearance and settlement of transactions in, including exercises of, binary options, and to foster cooperation and coordination with persons engaged in the clearance and settlement of such transactions, to remove impediments to and perfect the mechanism of a national system for the prompt and accurate clearance and settlement of such transactions, and in general to protect investors and the public interest. The proposed rule change accomplishes this purpose by applying substantially the same rules and procedures to these transactions as OCC applies to similar transactions in other cash-settled options except to the extent that special rules and procedures are required in order to accommodate unique features of binary options.
(B) Self-Regulatory Organization’s Statement on Burden on Competition
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OCC does not believe that the proposed rule change would impose any burden on competition.
(C) Self-Regulatory Organization’s Statement on Comments on the Proposed Rule Change Received from Members, Participants, or Others
Written comments were not and are not intended to be solicited with respect to the
proposed rule change and none have been received.
III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action
Within thirty-five days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to ninety days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:
(A) by order approve the proposed rule change or
(B) institute proceedings to determine whether the proposed rule change should be disapproved.
IV. Solicitation of Comments
Interested persons are invited to submit written data, views, and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods:
Glossary
Posted by admin in Binary Options, Bungee Options on July 21st, 2009
If you’re not completely familiar with ParagonEX or how Bungee options work, the glossary below could prove helpful for learning some common terms & phrases and getting yourself up-to-speed.
Bungee Options
Bungee options, also known as digital options, bet options, or all-or-nothing options, are contracts which have only two possible outcomes – either they win, or they lose — therefore Bungee by nature.
A Bungee option involves a fixed payout after the underlying stock meets or exceeds its predetermined threshold or strike price.
Values of Bungee options payouts are determined at the start of the contract and aren’t affected by the magnitude of movement of the stock value.
Bungee call options pay the predetermined amount providing the price of the underlying security exceeds the strike price at expiration.
Similary, Bungee put options pay the predetermined price if the price of the unerlying security is trading at less than the option strike price at expiration.
Bungee Call Options
Bungee call options gain value when the underlying security is trading at more than the strike price at expiration. Select “Call” to bet that the underlying security will exceed the option’s strike price at expiration.
Bungee Put Options
Bungee put options gain value when the underlying security is trading at less than the strike price at expiration. Select “Put” to bet that the underlying security will fall below the option’s strike price at expiration.
Payout
The amount of money earned from a trade or investment.
Strike Price
The strike price is determined by the price of the underlying security at the moment at which the option is purchased. When the option expires, the price of the underlying security is compared to the strike price to determine whether the option has gained value (”in the money”) or lost value (”out of the money”).
Expiration
The time and date at which the value of the underlying asset is judged against the strike price to determine payoff. At expiration, the option becomes void an ceases to trade.
In the Money
An option is said to be “in the money” if the option gains value upon expiration. A put option is “in the money” if the price of the underlying security is below the strike price. A call option is “in the money” if the price of the underlying security is above the strike price.
Out of the money
An option is said to be “out of the money” if the option loses value upon expiration. A put option is “out of the money” if the price of the underlying security is above the strike price. A call option is “out of the money” if the price of the underlying security is below the strike price.
At the money
An option is at-the-money if the strike price of the option equals the market price of the underlying security. This can also be considered the “break even point” since the option neither gains in or loses value and the payout equals the original amount traded.
Trade Bungee Options as a Hedging Strategy for Forex Trading
Posted by admin in Binary Options, Bungee Options on July 21st, 2009
Forex traders often encounter failure of their strategies in the dreaded stop-loss zone. This zone, adjacent to the breakout point, is the fuzzy area where we Forex traders often place stops to protect ourselves from further losses. Each Forex trader who trade options uses different rules for his stop loss point. Usually this is slightly above or below the breakout point. But as we have all experienced, the problem is that a breakout often tests the breakout price, sometimes dropping slightly below the breakout price, ’shaking us out’ of our trade. Therefore the stop-loss point becomes fuzzy, forcing us to choose lower and lower stop-loss points, and wearing us out each time we re-enter the same breakout point.
Trade Bungee Options using Bungee Hedging Strategy
One attractive possibility is to hedge our Forex trade using a Bungee option hedge. This is actually much simpler than it sounds. What it actually does is shift our risk from the stop-loss zone to the area above the breakout point, where the prices are more likely to rise and where the breakout is less likely to fail due to the properties of trader momentum.
Here we outline one such hedging strategy, using Bungee options trading to hedge against our Forex trades.
In this example, i place a trade of 1 mini lot EURUSD long, when its price crosses my breakout point of $1.00. Should the EURUSD test my breakout point before i exit this trade, i will place a $100 PUT Bungee option trade. What this does is shift my original breakout point lower, similar to a stop-loss, such that i am profitable as long as a test of the original EURUSD breakout point does not leave my Forex account with greater than a $70 loss. If I incur more than a $70 loss in my Forex account, then I immediately exit the EURUSD position.
This has effectively shifted the risk of breakout failure from the below the breakout point to above the breakout point. The attractive feature of this hedging strategy is that most breakouts are often tested slightly the below breakout point. Using this hedging strategy we protect ourselves in the area below the breakout point rather then get worn out using a stop-loss that is lower than the breakout point, which is the common Forex trader practice. And the best part of this strategy is that the risk has been shifted to the area above the breakout point (our Forex trade must make at least $85 profit in order to cover the Bungee option loss). However we know that as long as the breakout has not failed, we will more than likely cover this hedge. Remember, the breakout is most likely to fail BELOW the breakout point, but now we are covered.
Excotic and Digital Options
Posted by admin in Binary Options, Bungee Options on July 21st, 2009
While digital options find themselves among truly exotic trading vehicles, such as look-back options, chooser options and Bermuda options, they are the simplest options of all and individual traders can employ them, if only synthetically. A digital option is an option whose payout is characterized as having only two potential values – a fixed payout of, say $1, when the option is in-the-money or a $0 payout otherwise. The payoff remains the same, no matter how deep in-the-money the option is. Because the payout of a tight bull spread is closely similar to that of a digital option, so is its pricing. If a trading system has the capability of pricing a tight bull spread, it shouldn’t be challenging to price a digital option. Using a forex example, digital options let you wager on whether the exchange rate will trade above or below the trigger level at expiration.
ParagonEX Bungee Platform
Digital options typically are placed into the class of financial instruments referred to as “exotic.” However, digital options are simple, and can find a place in the average retail trader’s trading toolbox.
Exotic options are the tools of multi-million dollar OTC traders with big bank and other financial institutions backing them. It is rare for an individual retail trader to use these instruments, and for good reason. They are complex, expensive and relatively illiquid. However, while digital options find themselves among truly exotic trading vehicles, such as look-back options, chooser options and Bermuda options, they are the simplest options of all and individual traders can employ them, if only synthetically.
Webster’s dictionary defines the word exotic as “strikingly unusual or strange in effect, appearance or nature.” To consider whether this word is fairly applied to digital options, think of the everyday occurrence of opening your mailbox and finding two discount offers from one of your favorite stores. We evaluate both offers:
Offer I: $5 off every purchase of $15 or more – this is the conceptual application of a digital option.
Offer II: 20% off any single item – this is the concept of a plain vanilla exchange-traded index option.
Which one you pick depends on how much you want to spend in the store. Let’s say you only wanted to spend $20. You would exercise offer I and your purchase would cost you only $15. You also saved an additional $1 over Offer II that would have reduced your purchase price to only $16 ($20-(20%* $20))
What makes it Digital?
A digital option is an option whose 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.
The term digital is derived from the computing reference of a digital encoding/decoding system that can have exactly two possible states. For that reason, a digital option is also referred to as a Binary option, a binary number in mathematical or computer jargon is one where each digit can only have two possible values, either 0 or 1. Applying that terminology, an option that, at expiration, can have only one of two payoff possibilities, a 0 or a 1, is classified as a digital or binary option (these terms can be used alternately).
Payout for a Digital Option
Using the example of our two discount offers, we will explain the pay-out value for a digital option.
Binary call option: As any call option would, a binary call option pays out if the underlying or market price exceeds the strike price at expiration. The only difference here is that the payout is a preset amount, regardless of the difference between the market price and the strike price (see “Digital rewards,” right) .
In that context, if you spent $20 and exercised offer I, you received $5 off, making your total out-of-pocket purchase worth $15. On the other hand, had you spent $100, your savings would still be only $5, making your entire purchase now worth $95. (In the latter case, you were better off exercising offer II and receiving 20% or $20 off instead.)
Binary Put options: Correspondingly, the binary put option pays out the stipulated amount to an option holder only if the market or underlying price is below the strike price.
If any segment of an option payout graph is vertical – that is, it doesn’t contain a slope – your position has an element of a binary option, either on a standalone basis or embedded as a component of a compound option (an option on an option). The vertical aspect of the payout graph indeed reveals the existence of a binary option.
A speculator betting on rising and falling prices can use digital options as cheaper alternatives to regular vanilla options. A hedger uses this cost-effective instrument to effectively draw upon a rebate arrangement that will offer a fixed compensation (that is, payout) if the market turned the other direction.
A digital option can be simulated for pricing purposes and replicated for hedging purposes as an aggressive bull spread. A bull spread involves buying an option at a lower strike and selling a similar option at a higher strike; the difference in the strikes is the spread risk.
Because the payout of a tight bull spread is closely similar to that of a digital option, so is its pricing. If a trading system has the capability of pricing a tight bull spread, it shouldn’t be challenging to price a digital option. Keep in mind though, the more aggressive the bull spread, the higher its premium, and therefore the costlier your hedge. On the other hand, the less tight the bull spread, the larger the exposure to spread risk.Tools for the Trader
Using a forex example, digital options let you wager on whether the exchange rate will trade above or below the trigger level (strike price) at expiration. If exchange rates move unfavorably to the position, the holder exercises his option and trims his losses by a predetermined payout amount, whereas if the market moves favorably, the trader continues to deal in current spot prices and doesn’t exercise his option.
You may begin to wonder – why not just buy a regular option instead? The reasoning is that, in a volatile market, a digital option presents a cheaper alternative to the traditional vanilla option (and considering the cause/effect relationship, it therefore provides limited hedge capability).
Alternatively, if the trader is expecting a stable or relatively quiet market with low volatility, then the recommended strategy would be to write (sell) options, as doing so will generate profits in an otherwise unprofitable trading environment. Remember, the greater the flexibility and higher the payout for an unfavorable market price movement, the larger the upfront premium associated with purchasing that option.
Currency markets are event-driven and it is challenging to forecast the direction of market movement prior to important events. Digital options work well in these scenarios. Technical trading doesn’t necessarily bode very well for profit-taking before the scheduled release of key economic and trade reports. But if you expect increased volatility in light of the announcements, your best choice is to trade options and reduce returivrelat’ ed spikes and whipsaws.
A sophisticated trader can always develop flexible structures to maximize the risk/return characteristics of his portfolio by including options. Digital options might not necessarily be an excellent tool for following trends and are not truly adequate for maximizing profits either, but they help protect against a loss of profits. Trading pitfalls and jolts to profitability can be minimized if the digital options trader recognizes, among other things, the structural subtleties associated with specific trigger levels, related liquidity concerns, and stays alert to any warnings signaled by the greek ratios – delta, gamma, vega, etc.
Technological breakthroughs have made computing muscle affordable and available via sophisticated trading software and has simplified the pricing of these not-so-vanilla options. Marketing digital options as strikingly exotic might hinder demand and sometimes even daunt a pro trader from dealing in them. There is no golden rule that prescribes straightforward tactics for specific trading positions, but a skilled trader should evaluate these positions as a welcome break from the conventional tools and make a choice depending upon his sole appetite for risk.
What are Binary Options
Posted by admin in Binary Options on July 21st, 2009
Binary Option
In finance, a binary option is a type of option where the payoff is either some fixed amount of some asset or nothing at all. The two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security. Thus, the options are binary in nature because there are only two possible outcomes. They are also called all-or-nothing options, digital options (more common in forex/interest rate markets), and Fixed Return Options (FROs) (on the American Stock Exchange).
For example, a purchase is made of a binary cash-or-nothing call option on XYZ Corp’s stock struck at $100 with a binary payoff of $1000. Then, if at the future maturity date, the stock is trading at or above $100, $1000 is received. If its stock is trading below $100, nothing is received.
Binary options are usually European-style – for a call, the price of the underlying must be above the strike at the expiration date. American binary options exist also, but these automatically exercise whenever the price “touches” the strike price, yielding very different behaviour.
Binary Options – A Simple All or Nothing Position
As the name suggests, a Binary Option is a type of option where the payoff is all or nothing. Because of this characteristic, Binary Options can be easier to understand and trade than traditional options.
Binary Options are cash-settled as European-style options, i.e. they can only be exercised on the expiration date. If, at expiration, the options settle in-the-money, the buyer or seller of the options receives a pre-specified dollar amount. Similarly, if the options settle out-of-the-money, the buyer or seller of the options receives nothing. This provides a known upside (gain) or downside (loss) risk assessment, and unlike traditional options, Binary Options provide full payout due to a single pip movement.
Binary Options Have Two Outcomes
A trader of Binary Options needs to anticipate the expected direction of the price movement of the underlying asset. Unlike traditional options, knowing the direction of the price movement, as well as magnitude of the movement, is not required. If the investor has an opinion about an underlying asset and wants to places a trade, s/he can trade Binary Options.
There Are Two Ways to Take a Position – Buy or Sell.
Buy, if you believe the market price will rise or the economic event will occur. Sell, if you think the
opposite. If your insight is correct, on the expiration date, your payoff is the settlement value of your
contract.
Understanding Probability and Opportunity
The price of a Binary Option contract is equal to the probability of the event happening. For example, if
the contract value has a value of $100 and the last trade of the contract was at $96.00, it is an indicator
that 96% of the market believes that the event is going to happen and the contract will end up
in-the-money.
Advantages of trading Binary Options over Traditional Options
1. Binary Options are generally simpler to trade because they require only a sense of direction of the
price movement of the underlying asset, whereas traditional options require a sense of direction as well as
the magnitude of the price movement.
2. Binary Options have controlled risk to reward ratio, meaning the risk and reward are pre-determined
at the time the contract is acquired. Traditional options have no defined boundaries of risk and reward
and therefore the gains and losses can be limitless.
3. Binary Options provide nearly all the trading and hedging strategies that are possible while trading
traditional options. Binary Options maintain a level of trading sophistication and functionality.
4. Unlike a traditional option, the payout amount is not proportional to the amount by which the option
ends up in-the-money. As long as a Binary Option settles in-the-money by even one tick (regardless of
how much in-the-money it is), the winner receives the entire fixed payoff amount.
5. Binary Options offer contracts with short-term durations. In some markets, Binary Options contracts close multiple times throughout the trading day, while others may last as long as a quarter. This provides the trader with several investment opportunities and flexibility as markets change over time.
Where are Binary Options traded?
Binary Options have been enormously popular in Europe and are extensively traded in major European exchanges, like EUREX.
In the United States, there are a few places where Binary Options can be traded. The Chicago Board of Trade (CBOT) offers Binary Options trading on the Target Fed Funds Rate. To trade these contracts, traders must be members of the exchange or investors are required to trade through such members to execute a trade – the value of each contract is $1000.
The other exchange that offers trading on Binary Options is the HedgeStreet Exchange. Similar to the CBOT and NYMEX, HedgeStreet is a government regulated, financial trading exchange. Accounts on HedgeStreet can be opened and funded online for $100. HedgeStreet is a non-intermediated exchange, i.e., you do not need a broker to trade Binary Options on HedgeStreet.
Who trades Binaries?
Binary Options are traded by the following investors:
1. Tech savvy speculators who are willing to potentially make a profit in the market.
2. An investor following financial movements in the market, wishing to potentially earn a profit by taking
a position on the direction of a market price.
3. Investors who wish to hedge their risk on investments like crude oil, gold, silver, earnings per
share, currencies, and even real estate prices.
4. A bank or an institution wishing to hedge its interest rate or currency risk.
Tips to Trade Binary Options
1. Know the underlying asset – Binary Options derive their financial value from underlying assets.Before investing in a Binary Options, make sure you understand the underlying asset, are familiar with the relevant financial markets and where the asset is traded. Example: Silver Futures are listed on NYMEX/COMEX.
2. Know how to interpret a Binary Option price – The price at which a Binary Option is trading is an indicator of the chances of the contract ending in-the-money or out-of-the-money.
3. Know when to get out of a position – An intuitive trader acts promptly when he feels that his binary contract is going to end out-of-the-money at expiration. Example: You have a $75.00 Silver
contract that you feel is not going to expire in-of-the-money. Instead of holding it until expiry, selling it at $30.00 and neutralizing your open interest will help you manage the loss (i.e. $45.00 instead of
$75.00).
4. Understand the relationship between risk and reward – Risk and reward go hand-in-hand in binary option trading. The more the risk or unlikelihood of a particular outcome occurring, the greater the reward associated with it. An intelligent investor understands and weighs each contract on these two matrices before taking a position in a contract.
As an example, an investor who follows foreign currency movements senses that the USD is gaining ground against the YEN and wants to hedge his risk and try to protect his Japanese investment from dropping in value. He may do this by buying 10,000 binary contracts on HedgeStreet, which are “USD/YEN rate will be above 119.50” by 4:00 PM ET tomorrow. If his analysis is correct and the USD gains ground over the Yen, rising above 119.50, the 10,000 binary contracts will expire in-the-money, yielding a total payout of $1,000,000. If he paid $75 per contract, he will make $25 per contract, which is a $250,000 total profit – a 33% rate of return on his investment. However, if the Yen did not end above 119.50, the 10,000 binary contracts will expire out-of-the-money. In this case, the trader would loose his initial investment on the binaries, but would be compensated by the gain in value in his Japanese investments.
Examples of Hedging Using Binaries
1. Foreign currency traders or investors, who want to hedge their risk against adverse currency
movements.
2. Futures traders and dealers of precious metals like gold and silver, who want to hedge their risk against
weakening prices.
3. Gas station owners could hedge against crude oil price increases, which would represent increased
product costs to them.
4. Shareholders who want to hedge their equity risk against poor company performance that does not
meet analyst expectations or a potential merger deal that might dilute their equity.
5. Home owners who want to hedge their risk against weakening real estate prices.
6. Bond holders who want to hedge their risk against falling fed fund and inter-bank interest rates.