Binary Options

A binary option is a two-way option.  Either something happens or it doesn't.  You can choose (place a wager on) either of two outcomes.  Either you win or lose.

I have not yet mentioned binary options via this blog, but have had requests to do so.  Please keep in mind that binary options are much more akin to gambling than investing.  This product is not appropriate for most readers, and goes against my general belief that options are best utilized to reduce risk, and not for gambling.

Currently, the Options Clearing Corporation only clears binaries traded on the CBOE because the NYSE and AMEX no longer list any binary options for trading.

Here's how a binary option, often called an 'all-or-nothing' option, works:  It's a 'yes or no' proposition.  For example, look at a typical call option, the SPX Oct 1100 call.  If the binary version of this option is ITM when expiration arrives (remember that's Friday morning settlement), the option owner collects $100.  If it is OTM, the option is worthless.  That's it.  It does not matter how far ITM.  The payoff is zero when OTM and $100 when ITM.  You get $100 whether SPX is 1100 or 1200 or 1500.

On the CBOE, there is a
market in the options, with bids and offers.  If you buy or sell one of
these calls (or puts) at $50, you are getting even money on your 'investment.'  The options trade
with a premium between $0.01 to $0.99, and can never be worth more than
$1.00.

CBOE offers Binary Options on the S&P 500 Index (SPX) and the CBOE
Volatility Index (VIX). The ticker symbols for these Binary contracts are
BSZ and BVZ respectively. Expiration dates and settlement values are the same as for traditional options.

In the example, it's a wager:  Will SPX be at or above 1100 at expiration?  You can trade either puts or calls, so there is no concern about margin requirements when selling options.  If you want to sell the call, buy the put instead. 

Example:  You believe SPX will be below 1100 when the settlement price is determined on Friday.  You can sell the 1100 call and collect a cash premium.  Or you can buy the 1100 put and pay a cash premium.  Assuming these are priced efficiently, one trade is equivalent to the other.  If you are correct and sold the call, it  will be worth nothing and you keep your premium.  If you bought the put, it will be worth $100.  The profit should be the same, regardless of which option you traded.

Be aware.  If the closing price is 1100.00, the call wins and the put loses.  Thus, if you sold the call or bought the put, you lost.

If this gamble appeals to you, this is a reasonable wager.  The risk is that the bid/ask markets are too wide and that you will not get the odds you deserve.  But if you compare it with a racetrack, the house gets its 15%; if you trade with a bookie, he/she gets the vig (vigorish, or the charge taken for placing the bet), the odds available at the CBOE appear to be reasonable.

If you exit the CBOE and trade these binaries in Europe (online), the 'vig' becomes excessive.  So be careful.


Where to trade

Most trading activity (as far as I can determine) for binary options occurs in Europe.  You can do a Google search to find places to trade.  But, I have no idea how safe it is to open an account.  There is nothing similar to the OCC to guarantee the contracts.

Below is a link to EZ trader, one of the places to trade binaries.  There are no bid/ask spreads.  There is just a payoff percentage.  When you lose, you lose 100%.  When you win, you collect the stated percentage.  The odds are not fair.  On an even money wager, the payoff is far less.

For example, if the payoff is 65%, you either lose $100 or win $65.

Instead of choosing a strike price, they use the current price, at the time you buy your option.  Then you can choose 'end of day' or a shorter time period.  It looks as if that time period expires every 2:00 hours.  If you are a good technician, this may be a place to gamble.  I'm afraid that it's easy to get hooked.

If you are interested (despite my less than rousing endorsement), please use the link below:

Disclaimer:  If you open an account via the link below, I earn a commission:


Up to 75% Return in 1 Hour
New & Improved Options Trading Platform.
No Fees. Start Trading Now!
www.eztrader.com


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Conclusion:

Binary options can be another way to hedge a portfolio. If you have risk at a specific OTM strike for SPX, you may be able to buy some binaries at a low price on the CBOE. That gives you limited protection.  But the cost may be too high – especially when profit is limited.

4 Responses to Binary Options

  1. Rob1 10/20/2009 at 12:00 PM #

    Another Great Post..Very Educational
    I have a Q for U..yes again
    Do u know if the IV of the Nov call option would fall after the earnings. I have learned from you and now trying to trade a calendar spread. I am selling Nov calls and puts (290/230) and buying Dec calls/puts (290/230). I noticed per my calculations..I will lose money if IV drops significantly for Nov and Dec. But ISRG moves a lot after earnings and I was hoping that the IV stays the same or goes up. ALso we still have time for Nov OPEX so we might still have some IV in play. What do u think..

  2. Mark Wolfinger 10/20/2009 at 1:04 PM #

    I just hope no one gets the gambling bug from using these binary options. The odds seem so unfair.
    To keep it simple, expect the IV to decline. But…
    1) I don’t ‘know’ for a fact, but the odds are very hight that the IV of all options will decline after news is released.
    Keep in mind that the ‘pending’ news is one reason option premium is so high before earnings. Once the news is out, there is far less reason for anyone to speculate by buying options – and the bids disappear, and prices fall.
    2) It’s possible that the earnings news will be accompanied by announcements of more crucial pending news. In that scenario – IV would probably not decline. Example: story that the company is in talks to be acquired. This is more than extremely unlikely.
    3) Buying calendar spreads has two major risks:
    a) Volatility shrinkage. It is very likely that IV will decrease after earnings are realased. Yes, the stock moves a lot. But that movement is already priced into the options and is the reason they are already priced high.
    Calendar spreads are long vega (that means they widen as IV increases, and become more narrow as IV decreases). As a spread owner, you want to see the spread widen.
    Longer-term options are much more susceptible to losing money when IV drops than nearer-term options. Thus, if IV drops as expected, these calendar spreads should narrow and lose money.
    But…
    b) Calendar spreads are dependent on the price of the stock. Spreads widen when the underlying moves very near the strike price. So, if 230 or 290 turns out to be a good strike price, you may profit when the stock moves there.
    But, if the stock moves stock too far (to 210 or 310) or not enough, then you will certainly lose on this trade.
    Keep in ind that buying two calendars guarantees you will lose on one of them – and even if you profit on the other, it may not be enough to compensate for the loss.
    To be complete, there is the chance the stock moves towards one strike and you sell the calendar. Then it moves towards the other and you sell that one. Possible? Yes. But not very.
    Bottom line: This position is very dependent on the IV AFTER the news. Before making a trade like this, you should (in the future) determine the current IV; determine what the IV was last week and the week before and the month before; determine how much your spread will be worth if that previous IV becomes the IV after earnings. Also determine where the stock must be trading to earn a profit at that IV. Then decide if you want to make the bet.
    Lots of work? Yes. So get used to using a calculator or position simulator.
    I cannot tell if this is a good trade or not. I am unfamiliar with the options and don’t know how IV has performed in the past.

  3. Scott M. 10/21/2009 at 10:02 AM #

    Mark, I have read that it is possible to be right about the direction of the stock and the timing and still lose money at expiration. Can you give me an example? My understanding is that I could exercise the call option or sell the option for a profit.
    2. If I am correct about the direction and timing of a stock and the option/stock is out-of-the-money by several points, I could exercise the option, sell the stock, and keep the profits. Do I have to have sufficient funds in my account while the option is active in order to buy it at the strike price? Hypothetically, I could control $2500 of stock for $500 worth of options. Does this mean I have set aside $3000 ($500 for the premium and $2500 in case the stock reaches the strike price) until exercise or expiration?
    3. If a strike price is in-the-money at the time of option purchase, is it possible to exercise the option at any time? For instance, SRZ last traded for $4.28 and has a November strike of NOV 2.5. It has an ask of $2.15 for a breakeven of $4.65.
    4. In theory, I could buy a put option for $1 a share on a stock trading at $24 with a strike price of $24. If the stock dropped to $19, I could then exercise the put option with the right to sell it at $24 per share for a $5 per share profit, minus permuims. Is this correct? Who would buy the stock at $24 a share?
    5. What is the difference between a put and a naked/uncovered put? Is it true that in both options, you do not own the underlying stock?
    6. If you sell a put and the stock drops and is assigned to you, do you have to maintain sufficient cash to cover the stock purchase at or below the strike price until the option is exercised by the buyer or expires?
    Thanks for all of your help!

  4. Mark Wolfinger 10/21/2009 at 1:57 PM #

    Scott,
    I am deeply troubled by your problems. I decided to provide lengthy, detailed responses. in return, I hope you will reply to the questions I direct to you.
    The reply will appear Oct 22 and 23, 2009