Binary options are based on a simple proposition; will X market reach Y level by Z time. Binary options ask a “yes” or “no” question, the answer of which creates a certain outcome. Binaries trade between 0-100, if the answer to the question is yes at expiration, the option settles at 100; if the answer is no, it settles at zero.
It can be based on any underlying: a sporting event, election, economic report or unique situation, but is mainly based on existing markets.
The modern history of binary options is a relatively short and sometimes ignoble one.
The Iowa Market was launched in 1988, using binary-type contracts as a way to educate people regarding markets and operating under a no-action letter from the Commodity Futures Trading Commission (CFTC). They created binary contracts on the outcome of elections. What was learned from this is that people putting actual money down on an outcome were better at predicting those outcomes than certain so-called experts. Putting money on the line apparently created the incentive to do a little more homework. In fact, there is a long history of presidential betting markets and the idea that they have a strong predictive value.
In the early part of this century, a number of nascent binary option exchanges — most of which were based outside of the United States — were developed often on events such as sports.
“They weren’t exchanges; most of them were the offshore Cypriot bucket shops at the time,” says Dan Cook, director, business development for the North American Derivatives Exchange (Nadex).
Cook says they were mainly based in countries with light regulations. “They were promoting binary options, but essentially it was a bunch of bad actors that were taking people’s money,” he says. “There were only about four or five technology providers. Some would have 200 affiliates, which were white-labeled websites. That was the difficult thing in trying to stop it. They would close one down and another would pop up. They would be saying 70% returns in 60 seconds. There were a lot of bad actors in this space.”
There were also more serious ventures. Irish firm Intrade launched as a prediction market in 2001 and operated Tradesports, which offered contracts on various sporting events. Tradesports marketed itself as a way underlying commercial interests could hedge their exposure to wins and losses as well as a market for speculators.
At the time officials of the CFTC often chose to ignore many of these markets, arguing that sports betting markets masquerading as futures exchanges were more a matter for individual state gaming commissions than the U.S. futures regulator.
Intrade itself offered a popular presidential election market where traders could make bets on the outcomes of numerous U.S. elections. It became popular during the 2008 and 2012 elections and did provide some support to the notion that there could be a market where participants put up their own money.
“We filed for presidential election contracts around 2012 and the CFTC said “No,” but you turned on CNBC and they are quoting the Intrade markets every day,” says Cook.
Intrade had applied for Designated Contract Market (DCM) status with the CFTC, but that was not granted and the market was closed in the United States in 2013.
By this time the CFTC had better actively monitored some of the more questionable binary option products and issued a fraud alert in 2013 geared at binary bucket shops.
In 2004, Hedgestreet, which would later be purchased by IG Markets and rebranded as Nadex, became the first regulated DCM offering binary options. Users could open an account directly with Nadex without having a clearing arrangement with a futures commission merchant. All contracts are fully collateralized so there are no margin calls. Nadex offers contracts tied to underlying markets, including stock indexes, forex, commodities and events. It offers weekly expirations, daily expirations and numerous intra-day expirations.
Futures markets have long had a reputation for eating new lightly funded participants up. Numerous studies have found that most new accounts bust out, usually because they are underfunded and traders misuse the available leverage. “They want to be a trader and they try and trade an oil contract and they have $10,000 in their account. They don’t stand a chance with a $1,000-a-point move,” Cook says. “What we wanted to do is give the average individual a way that they could be active in the financial markets, but in a sensible manner. They can trade the popular markets like gold and oil based on those actual underlyings, but they can do it at a lower cost with limited risk.”
In its early days as Hedgestreet, Nadex toyed with the idea of creating contracts for potential hedgers where no market existed, such as gas at the pump, but more recently it has focused binaries on popularly traded markets.
“What is popular are markets that people know and see on the news every day. They wanted to participate but they didn’t have the opportunity,” Cook says. “People like to trade currencies, but currencies are elusive because of high leverage. They were trading very large contracts. They were able to do that because of the high leverage, which is great if it is moving in your favor; but as you know if it moves rapidly against you, people’s accounts can get crushed.”
Nadex has grown in popularity, and volume (see “Growing an exchange,” right). It has added market makers, and in 2010 allowed for trades to be intermediated, though most customers still trade directly through exchange accounts.
Tom O’Brien and his son, Tommy, COO of TFNN, not only trade binaries but also operate TFNN Corp., a full-time trading education business with live content all day, talking trading and taking calls with a variety of hosts.
Tommy trades binaries and directs many traders to the contracts. He says many new traders are part-time traders without the ability to monitor positons 24 hours, so the defined risk nature of binaries is a huge benefit. “Defined risk is a huge deal,” Tommy says. “They know that if they are putting up $25 to get $75 that is all they are putting up. We all know the currency markets are brutal. It is a safer way to do it. They can start out small with recreational trades; the barrier to entry is not very large, they don’t have to wire in $10,000.”
He adds that they want to be in the market and they want defined risk. “They know they are not going to wake up in the morning and find out they lost $10,000; if they got a couple of thousand at risk, they got a couple of thousand at risk and they know what the risk is.”
O’Brien says, “I trade gold all of the time, but I will never trade it again in the futures market. It doesn’t make sense because the spreads on Nadex are $1 at most. Gold is going to bust up or down $10 in a heartbeat. They can trade gold $6 in-the-money with a couple of hours to trade. That can move. That is a low risk, high reward trade.”
They take advantage of the intraday contracts to trade economic reports and news. “When [the EIA oil inventory report] is coming out at 10:30 and [hourly] binaries are expiring at 11 or noon, and your option is at 5; that is a small amount of premium you are paying when news is breaking. There can be a lot of volatility on those numbers,” Tommy says.
They also can trade volatility by buying an option strike below the market price and selling one above it. “If gold is trading at $1,200 per ounce, you buy a binary at 1210 [and] you sell a binary at 1190. You are looking for a $10 up or down move. And a $10 out-of-the-money binary is going to be really affordable in gold,” Tommy says. “You are paying maybe $20 on each side, so you are putting up $40 in total, and if one of them expires in-the-money you get $100 in value.”
O’Brien says having defined risk allows traders to make bets before news and in volatile markets too risky for straight futures, such as during the recent presidential election spike. “I wouldn’t have wanted to be trading futures that evening, but it made sense with binaries.”
Jim Prince is head trader and educator with the Greatest Business on Earth, an educational portal for BarCharts.com, who initially looked at binaries a few years ago and is now hooked and encourages new traders to trade them. “People get involved in trading and are often undercapitalized. Binaries gave that individual a good opportunity,” he says.
“As I started to delve into it, one thing jumped out: capitalization — you didn’t need to lay out a bunch of capital. That has always been [difficult] for newbies. They open up an account for $5,000, blow through that and never come back. You can open up an account for $250 at Nadex and try your hand and still experience some of those emotions. That and the aspect of risk. Whenever you open up a trade you have a known risk.”
Prince has developed a binary trading course. “It is a great launching point; I don’t care if you have $250 or $250,000 to trade with, if you don’t understand how the markets work, it is not going to matter. Binaries allow you to start with a small amount at your own pace. It is a fantastic tool to begin your trading career with.”
After being the only regulated exchange for a while, Nadex is now facing more legitimate competition. The Cantor Exchange lists binary options on forex markets and has recently offered weather market binaries.
Working with AccuWeather, Cantor offers contracts on hurricanes tied to specific zip codes, rain days, and will soon offer snow contracts. As opposed to Nadex, Cantor is looking at creating markets that are particularly appropriate for the unique attributes of binaries.
“Our interest is mostly trying to figure out where binaries have a real strong economic purpose, says Richard Jaycobs, president of Cantor Exchange. “Weather is a perfect example. If it snows and somebody has to pay someone to plow their parking lot, that is real money. We are looking at a whole new class of binaries and weather is the best example of that.”
Cantor offers protection for a hurricane landfall. “You can actually go out and say, I have a house on the Jersey shore and if a hurricane landfall occurs within 75 miles of the zip code that my house is in, I want to get paid, maybe the amount of the deductible I have on my insurance,” Jaycobs says. “If you buy a binary contract and a hurricane happens near your house this season, it may cost me $800 to $1,200 to get $10,000 worth of protection. We think those are more interesting kinds of contracts.”
The contracts are listed on tradewx.com and are valued at $1, so you basically buy the specific dollar amount of protection you are looking for.
Cantor has two other weather-related contracts on rainfall. Small businesses that depend on vacation rental income can hedge the cost of bad weather. Right now it is only in the vicinity of Atlantic City, but the goal is to expand regionally and nationally.
“The product that people want — and this is the key part of our strategy — varies by area. There are some areas where people don’t care about rain, they care about wind; there are some areas where they don’t care about rain or wind, they care about hail damage. We have the technology to get very particular with risk and offer them,” Jaycobs says.
Their target customers are small businesses up to institutional. People hedging exposure of $10,000 to $100,000. “All of it focused on trying to identify some hedging community that can benefit from the product, which is not insurance but fills a gap in what insurance would do and nothing,” Jaycobs says.