Trade in Groups

A binary option is an all-or-nothing contract. The prefix “bi” denotes two possible outcomes for the investor. Other common names for binaries include fixed return options (FRO), all-or-nothing options and digital options for their on-off payment structure. Binary options are a new investment vehicle to hit the American Stock Exchange (AMEX). The contract calls for a fixed cash payout or fixed asset amount upon finishing “in the money.” If “out of the money” at expiration, the investor receives nothing and faces a maximum loss of their premium cost. Binaries appear in a variety of markets including commodities, currencies, indices, rates and even events.

Binaries seem to work in groups of two! There are two types of binaries to place bets on: the finish high FRO and finish low FRO. Just like normal vanilla options an investor pays a premium for the contract with a specified strike price, expiration date and underlying reference unit. The logic behind a finish high FRO is just like a standard listed call option. The investor is bullish on the underlying reference unit and believes the AMEX FRO Settlement Index will be at least $0.01 above the strike price and “in the money.” The logic behind a finish low FRO is just like a standard listed put option. The investor is bearish on the underlying reference unit and believes the AMEX FRO Settlement Index will be at least $0.01 below the strike price.

In binaries the settlement price is an index, namely the AMEX FRO Settlement Index referenced above. This is a key difference from standard vanilla options. Usually the underlying instrument price will close at a different value than the AMEX FRO Settlement Index. The index represents the average share value of a group of shares traded. The index is updated every fifteen seconds for investors on trading days. Such an index was instituted in hope of avoiding price manipulations.

Binaries seem to simplify the options game which helps less experienced investors. Having said that, sophisticated financial institutions, hedge funds, and other market movers use the investment vehicle in their portfolios. Agricultural and transportation companies use binaries to hedge against weather events (rainfall, tornadoes, hurricanes, etc.) where predictions are not always dependable. In other cases, investors place inflation bets against the Consumer Price Index (CPI) and Producer Price Index (PPI). Another example where binaries are helpful is in currency markets. Particularly illiquid and unstable currencies from emerging markets such as the Thai bhat or Turkish lira. Low volume creates illiquidity in these markets. Geo-political and economic instability make the currency prone to swift “jump risk.” Because of high risk associated with these currencies, higher required returns are expected. A currency trader can borrow stable, lower return currency like the euro and invest in high risk currency from developing economies. Speculators will use binaries to hedge their risk against volatile developing currencies.

I recommend you visit the American Stock Exchange website at the following link: AMEX. Find “Options” on the left-hand navigation bar and click on it. Next, find “Product Information” and click on it. Finally click on “Fixed Return Options.” This will lead you to a list of twenty securities that binary contracts can currently be purchased on. The list includes stocks, exchange traded funds (ETF) and trusts.

Written by Ryan Swift