Binary options may still be an obscure product, but that does not mean they are abstruse or threatening. This simplified version of options in fact has advantages that make it more suitable for some users – perhaps especially for beginning investors in options.
Until recently they were hard to obtain, but a new generation of web-based electronic trading platforms, as well as several market innovations designed to simplify the trading decision, are generating excitement and activity in retail binary options trading.
Heads or tails
A binary option, also called a digital or fixed return option, has only two possible outcomes at expiry, each of which pays out a fixed value, depending on whether or not a certain condition has been fulfilled.
In most cases, the value of a binary option is based on the price of an underlying security or asset. The condition is that the price must reach or exceed a certain level for the option to expire in the money and pay the higher value.
This higher value can represent a return of 70% or even more of the amount initially invested in the option. The lower value represents a loss.
A distinguishing feature and investment advantage of a binary option is that it need only expire in the money by just one tick to pay the higher value. Binary options thus provide a way for customers to earn a significant return even when markets are tranquil.
In contrast, a larger market move is required to earn positive return on the purchase of a regular option, whether a call or put, as the expiration price must lie sufficiently beyond the strike price to at least recoup the cost of the option premium.
A long gestation
Binary options have, for some time, been available over the counter but they are typically marketed as exotic options to institutions and often packaged with other derivative-type products.
In the US, the retail customer had to wait until mid-2008, when the American Stock Exchange and Chicago Board Options Exchange listed binary options on select stocks and indices. However, these have not attracted any significant retail customer base.
During the last few years, though, a web-based electronic retail market has developed that is becoming popular, especially among investors with little prior investment experience or who have limited risk capital.
This nascent market is reminiscent of where the retail forex market was eight or 10 years ago. It is a new investment alternative with low cost entry where all trading is conducted over a web-based, real time platform on which customers can trade with a simple click of the mouse. Online tutorials and a demo trading account are usually provided.
But unlike the retail FX market – which over the years, at least in the US, has become more expensive through curtailed leverage and rising minimum account funding requirements – binary options are and should continue to be affordable.
In fact, a customer can select a desired investment in a binary option to match his or her desired risk exposure starting from as low as $50 or even less.
Just you and me
Like the OTC market, web-based trading of binary options is between the customer who buys and the principal dealer who sells.
The principal dealer earns income by selling options at a slight premium or mark-up to their theoretical fair value and, in turn, typically does not charge the customer a commission fee or separate premium. The investor’s only outlay is the principal amount invested.
In general, once an option is purchased, it is held until expiration and cannot be sold. Nor can it be exercised before expiry. Binary options commonly expire in one hour and can be purchased up to 10 minutes before expiration. New options are offered every hour during the trading day.
Look up, look down
While several kinds of binary options are available in the retail market, the most common is the above/below or high/low binary option.
This will return the maximum value – say, $1.70 for every invested dollar – if the option expires in-the-money. This occurs when the expiration price of the underlying is above the option’s strike price in the case of a call, or below the strike price in the case of a put.
At any time that an option, whether call or put, is offered, the strike price is the current market price of the underlying instrument. Buying that option “locks in” the market price as the strike price.
The above/below binary option reduces the investment decision to one of pure direction. If the customer expects prices to rise, he or she will buy a call option and if he/she expects a fall, a put.
This simplicity appeals to many beginning investors, especially those who view regular options trading as complex, even overwhelming, given the wide range of available strike prices and maturities.
Moreover, the short life of a binary option means the customer need only predict price movements over, say, the next hour and not over several days or weeks, as typically required when buying a regular option.
Valuing the option
The diagram, Profile of a binary call option, shows the expiration value (solid black lines) and theoretical value before expiration (blue curve) of an above/below binary call option that has two values at expiration, V1 and V2, where V2 > V1. The greater expiration value will be realised if the price of the underlying instrument, P, at option expiry is greater than the strike price of the option, X.
Profile of a binary call option
Like its regular counterpart, a binary option’s theoretical value before expiration responds to changes in the component variables.
Since the theoretical value is a smooth function in P, it can be differentiated with respect to P and this provides the delta of the binary call option, or price sensitivity with respect to changes in price of the underlying.
As the option approaches expiry, the theoretical value will collapse to the expiration value, as indicated by the blue arrows. The theoretical value is sensitive to the volatility in price of the underlying instrument, widening away from the expiration value around the central inflection point as volatility increases.
Binary options also have some unique features. For example, so long as the probability density function of price changes used to compute a theoretical option price is symmetrical around a mean of zero – as is typically the case – then the theoretical value of an above/below at-the-money binary option will lie midway between the two expiration values. This is invariant to changes in time to expiration and volatility.
Also, an above/below at-the-money binary call option will have the same theoretical value as an above/below at-the-money binary put option that has the same payout.
The investment decision
The degree of confidence (expressed as a probability) a customer needs to have that a purchased above/below binary option will expire in the money can be calculated by comparing the expected net gain with the expected net loss as follows:
p(net gain) + (1-p)(net loss) = 0
where p is the probability that the option expires in-the-money. If C is the cost of the binary option, then:
net gain = V2-C and net loss = V1-C, so that
p = -(V1-C) / (V2-V1)
Consider, for example, an above/below binary option that costs $100 and will return $170 if it expires in the money and $10 otherwise.
Using the formula above, a customer will buy this option only if he or she assigns a probability greater than 56% to the likelihood that it will expire in the money. Since a probability of 50% represents a pure guess, the customer need only be a little sure of his/her price prediction.
To put it another way, over repeated trials, if a customer is correct at least 56% of the time in predicting price moves, buying binary options should result in net profit.
In contrast, as illustrated in the diagram Binary call vs regular call, buying a regular option can be a more difficult decision as the price of the underlying must move farther in the right direction to yield a net profit.
Binary call vs regular call
The price of the underlying instrument at option expiration need only be above the strike price, X, of this above/below at-the-money binary call option in order to realise the option’s maximum value (green shaded area). In contrast, the price of the underlying instrument must rally by more, to beyond Pb, before the corresponding regular or vanilla call option earns a greater payout (black arrow). Many traders may have more confidence in their ability to predict the former than the latter. For them, binary options may be the logical choice.
How it works in practice
Web-based retail trading of binary options is available on the major foreign currency pairs, precious metals and several actively traded US stocks.
The example on the screenshot below illustrates the simplicity of investing this way. A customer can purchase above/below binary call and put options on the shares of Google (GOOG) that have a 70%/10% payout. These one hour options started trading at 2pm and will expire at 3pm, about 51 minutes after the moment of purchase. They will stop trading 10 minutes before expiration, as indicated by the vertical dashed line at 2.50pm. The current share price of Google, and hence the strike price available now, is shown as $571.15 and the tick-by-tick movement of this price since the options started trading is shown by the blue line chart.
Trading Google (image by permission of StartOptions)
A customer who believes the share price of Google at 3pm will be above the current price of $571.15 will click on the green Call icon to buy a call option at that strike price. The opposite view is expressed by clicking on Put.
In either case, if the customer’s price expectation turns out to be correct, he/she will earn a net return of 70% of the amount staked. In this case, a $100 investment will return $170.
Customers who bet wrong will receive only 10% of their initial investment – in this case, $10, resulting in a net loss of $90.
After purchase, the customer can watch the share price tick by tick right until 3pm, when the expiration price is displayed on the trading platform.
Watch this space
Web-based retail trading of binary options is in a growth phase. Besides the features described above, customers can no doubt look forward to an increase in the range of underlying instruments that can be traded, as well as enhancements and extensions to the functionality of the electronic trading platform, all of which will further drive customer interest into retail binary options trading.
Rick Thachuk is president of the WLF Futures, Options and Forex Education Network, a group of US websites that exists to educate investors about trading opportunities. WLF does not make money by offering binary options trading services, though it does receive advertising from firms that may do so.
www.worldlinkfutures.com