It’s win or lose, nothing in between. That’s how binary options work. In other words, if you buy a binary option and:
A happens by B, then you receive C.
A does not happen by B, then you receive nothing.
“A” is the event defined by the exchange listing the option. Examples include gold achieving a certain price per ounce, a corporation filing for bankruptcy, or the Federal Reserve cutting its target for the Federal Funds rate.
“B” is the date by which “A” must happen.
“C” is the amount of money, or asset, you stand to gain.
The seller of a binary option, by contrast, must pay C if A happens by B. The seller is compensated for assuming this risk, according to the current market price for the binary option in question. Of course, the seller pays nothing if A does not happen by B.
Binary options differ from plain vanilla options in that a binary option’s payoff does not increase the more it is in-the-money at expiration.
A typical corn put option with a $3 strike will be worth $0.50 if corn settles at $2.50 per bushel on option expiration day. Alternatively, a binary put option with a $3 strike with a payoff of 1¢ per bushel will pay only that 1¢ no matter how far the price of corn falls by expiration day. See “All or nothing” for a graphical representation of the payoff profile of binary options.
HISTORY OF DIGITS
Binary options have long been used on the over-the-counter market, the peer-to-peer or dealer network marketplace where large financial institutions establish custom positions in non-standardized contracts without the intermediation of an exchange. As with many other OTC derivatives, these binary options are sliced, diced and accessorized to accomplish any number of specific financial goals.
Examples of these more exotic representations of binary options include one-touch binaries, which pay off if the price of the underlying hits the strike anytime before expiration; ladder binaries, which include a series of payoffs at different levels; and range binaries, which pay off if the price of the underlying stays within a set range.
Despite their popularity among big-money players, most of us are familiar with binary options due to their prevalence in a financial arena as far removed from the OTC market as any other – and we probably don’t even know it. Liquidity, logistical, infrastructural and regulatory considerations notwithstanding, many gaming Web sites offer good examples of simple binary options.
Such sites allow users to bet on anything from the outcome of football games to presidential elections to, yes, the level of the S&P 500 on a certain date. These bets pay a set amount, usually quoted as $1 per “contract,” to the “buyer” if the event (the Bears beat the Packers, the incumbent loses or the S&P closes above 1410 on Dec. 8, 2007) occurs. Only recently, however, have these basic, intuitive products found their way to regulated financial exchanges in the United States.
RETAIL ALTERNATIVES
Individual traders have a few alternatives in exchange-traded binary options. Here’s what’s available:
In July 2006, the Chicago Board of Trade (CBOT) started offering binary options based on the results of Federal Reserve monetary policy decisions.
In July 2007, the Chicago Board Options Exchange (CBOE) started offering binary options based on corporate credit events, such as a company defaulting on previously issued bonds, followed in August by broader, sector-based credit events.
In October 2007, the U.S. Futures Exchange (USFE) started offering weekly binary options based on the prices of crude oil, gasoline, gold, silver and the euro.
The CBOT already owned the market in standard Federal Funds futures when it launched its binary option contracts on the same. The Fed funds futures trade with respectable volumes and are widely quoted as reliable predictors of changes to the Fed’s target Fed funds rate.
The CBOT binary options pay $1,000 to the buyer at expiration if the option expires in-the-money. They are quoted in terms of 100 minus the target Fed funds rate. Calls expire in-the-money if the target rate is above the strike price at expiration. Puts expire in-the-money if the target rate is below the strike price at expiration.
The CBOE offers two classes of credit event binary options (CEBO). There are single-name CEBOs and basket CEBOs. Single-name CEBOs are cash-settled call options that pay $100,000 when a pre-defined credit event occurs. Examples of possible credit events that the CBOE might use as the basis for the options include, but are not limited to, a bankruptcy or a default on a certain debt obligation. Initially, the CBOE listed single-name CEBOs based on General Motors Corp. (GM), Ford Motor Co. (F), Hovnanian Enterprises Inc. (HOV) and Standard Pacific Corp. (SPF). The basket CEBOs are similar, but they are based on the credit performance of all the companies included in the basket and can pay out when one or more of the companies in the basket defaults, declares bankruptcy or satisfies the conditions of the pre-defined credit event.
Although the CBOE’s binary options are unique and enormously flexible in terms of how new contract specifications can adjust to current events, they are more useful to institutions that have large exposure to corporate-issued debt or debt exposure spread around a number of companies in a certain sector.
The binary options at the USFE, however, were designed with the retail trader in mind. These contracts are active for one week at a time, and listings include at least nine strikes for each referenced market. They have a payout of $1,000 per contract. The USFE offers two types of binary options: single-asset binary options and event binary options.
Single-asset binary options expire in-the-money if the underlying settles above the
option’s strike price at the end of the week. Single-asset binary options open for trading on Monday morning and expire on Friday afternoon. Event binary options expire in-the-money if a pre-defined event occurs; so far, the USFE has listed event binary options on whether the CME or InterContinental Exchange would merge with the CBOT. “What’s out there” (below) lists the major contract specifications of the CBOT (now CME Group), CBOE and USFE binary options.
THE WAY YOU MOVE
Binary options’ simple win-or-lose, all-or-nothing payoff structure takes a lot of uncertainty off the table. That means that the going market price for the option itself is an effective probability forecast of whether the event will take place. For example, USFE single-asset binary options are quoted between 0 and 100. The value can be considered the implied probability that the contract will expire in-the-money. In other words, if the $800 strike gold call option is trading at 97 on Thursday, the market is implying there’s a 97% chance that gold will settle at or above $800 when the market closes the following day.
The clear probabilities make it easy to verbalize your risk and reward in a potential trade. In other words, a $970 investment (97 x $10 point value) has a 97% chance to make $30 (3 x $10); alternatively, you could sell the option for $970 for the 3% chance that you’d get to keep the premium. If either looks like a good deal to you, given your personal analysis of the gold market, then there’s a trade to consider.
One interesting attribute in binary option pricing is that they tend to appear somewhat one-sided during periods of price trends and more balanced at perceived turning points or during periods of uncertainty. A good illustration of these periods is when the Federal Reserve is considering shifting its monetary policy bias from contractionary or expansionary to neutral, or vice versa.
Assume the Fed has been on a tightening binge and the target rate is currently at 6.50%. You’ve crunched the numbers and believe that it’s about time rates should stabilize or even drop. Based on current unemployment, housing starts, the dollar/euro rate, etc., you think there’s a 70% chance the Fed will stop raising rates, with a 40% chance they’ll hold steady and a 30% chance they’ll actually shift gears and decrease the target rate by 25 basis points, to 6.25%. That leaves a 30% chance the Fed will continue tightening and raise rates by 25 basis points, to 6.75%. You can play this analysis any number of ways. You could sell both the at-the-money put and the at-the-money call, which have the strike of 93.50 (100 – 6.50). If the market agrees with your analysis, you will collect $300 per option. If the Fed does nothing, the options expire worthless and you will keep the total $600 you collected. However, if the Fed raises rates, you will pay $1,000 on the binary put you sold, for a net loss of $400. Likewise, if the Fed lowers rates, you will pay $1,000 for the binary call you sold, for a net loss of $400.
Binary options also are useful when it comes to so-called six-sigma events – those market shocks that seem to take everyone by surprise and result in incredible profits and losses. Although it’s often pointed to as a classic mistake of beginning plain vanilla options traders, buying far out-of-the-money binary options with the hope of cashing in on these events is a bit more defensible for two reasons. One, because their payout is capped, binary options are generally cheaper. Two, in the case of binary options quoted from 0-100, the implied probability that the event will occur is laid out in front of you; you may be betting on a highly unlikely outcome, but at least you will know first-hand just how unlikely it is.
As a trader, it’s always better to have additional choices in how you risk your money. At some point you may become overwhelmed with which route to take, but once you understand the lay of the land, having the opportunity to choose among several ways to trade a forecast can mean the difference between winning a little and winning a lot. Binary options are a relatively new route on the retail trading landscape. Binaries have gone from a gimmick first popularized by the Iowa elections market as a way to legitimize sports gambling to a mechanism to hedge economic reports, but the binary structure is now being applied to traditional futures markets. Although a binary option won’t always be the right choice, and could even leave a lot of money on the table in the event of a big move, being able to trade it when you want it is a nice option to have.