The easiest way to cut through a cluttered commodity like stock talk is to create an exclusive, premium area – this filters out the annoying spammers and pumpers, because the people who are participating actively want to partake in exchanging information. Of course, this runs into a problem because even the best premium investing content sites have a hard sell pitch in a world of increasingly disintermediated investing information – so who would want to pay for access to RealMoney at TheStreet.com, as well as a premium forum subscription for discussion? The solution, it turned out, was creating an online brokerage built around the idea of turning customers into a community. This eliminates the problems with undesirable members, and allows for people interested in such a service to naturally gravitate together. The first mover in this space to achieve notable scale was TradeKing, and although their model is now being copied by brokerages like Scottrade, imitating something reliant on network effects to deliver value is a poor business model.

Network effects, as most business school students would know, is a trait whereby a product has more value given the number of existing users – think the telephone, fax machine, EBay, and the like – and note how those are all communication devices, just like online investing communities. Because TradeKing made community an integral piece of their platform from early on, it obviously attracted people who valued that service, and as their business grew it only reinforced the trend that traders looking for a serious place to discuss their ideas would use the TradeKing community site.

Contrasting with this is new offerings from brokerages like Scottrade, where a cursory view of the members makes it seem like a gathering of tech support personnel. Because Scottrade has never had a community-style site before, it remains to be seen whether their existing clientele has any interest in such a feature – and it’s particularly difficult to get a forum started with only a handful of members participating. TradeKing’s established user base means it has a higher volume of posts, more members looking to discuss trading and options, and this should be self-reinforcing over time. Scottrade’s major group effort right now is geographically linking members together, and actual investing conversation is scarce. Think about it: if you wanted a place to discuss trading and learn new techniques, where would you want to go? The obvious answer is the place where you’d be talking to the most people, and that place would be TradeKing.

This isn’t meant to be overly critical of Scottrade’s efforts, but merely to point out that not every company can be good at every facet of business; for example, Scottrade does have a very good setup for managing low-cost retirement accounts. But trader networking has never been a key point of having an account there, and I doubt it ever will be. TradeKing, on the other hand, is geared more toward traders (particularly of options) who want to have the ability to chat with like-minded people in a conducive environment – that’s simply how the management team at TradeKing (where the CEO maintains a blog full of great entries) wanted to run their business. While the Scottrade website requires opening a brokerage account beforehand, you can check out the TradeKing community site without any such obligation.

Of course, this can still be quite confusing. Binary options are not available with each and every stock out there. A matter of fact, it can be hard to find the ones that offer this option.

The CBOE lists two stocks with binary options - VIX and SPX. The American Stock Exchange lists stocks with binary option as FRO and include Apple, Inc (AAPL), Cisco Systems, Inc (CSCO), Citigroup Inc (C), DIAMONDS (DIA), General Electric (GE), Goldman Sachs (GS), Google Inc CL.A (GOOG), Home Depot (HD), IBM (IBM), Intel (INTC), iShares MSCI Emerging Markets (EEM), iShares Russell 2000 Index Fund (IWM), JP Morgan Chase (JPM), Microsoft CORP (MSFT), Oil Service HOLDRS (OIH), PowerShares QQQ (QQQQ), SPDR S&P 500 (SPY), Select Sector SPDR-Energy (XLE), Select Sector SPDR-Financial (XLF) and Wachovia Corp (WB). Every stock exchange has their own binary options, so you will have to learn which ones are available with this type of option or listed as FRO’s.

Now, to explain the concept. Binary options give investors a wide variety of trading options in that some are short-term trades while others may be quarterly since they are based on the date of expiration. You as a binary option trader will choose the stock that you wish to buy or sell by if you believe the price will go up or down on the date of expiration. If you think the market price is going to be higher then you buy. If you believe the market price will go down then you sell. If you choose correctly, then you receive payoff on each contract you had on that stock.

Normally, the price you will receive is a fixed amount, such as $100. This means you will receive $100 for each correct contract. If you buy and spend $25 and the stock rises or are equal to the strike price on expiration, you will receive $100 for each contract. However, if you are not correct you will lose your investment all together.

Metals and energy can also be bought and sold with binary options and be watched through the New York Mercantile Exchange. With the economy the way it has been heading, many investors are buying and selling foreign currency with the hopes of making a quick buck while others are looking to natural gas or crude oil.

Example of buying a stock with binary options

Light Sweet Crude Oil (CL)
The strike price for buying (calls) is at 20000
The strike price for selling (puts) is at 8000

Looking at the market and the strike prices you can make an educated decision in which way you believe the stock will go. Let’s say you buy. The last strike price for calls was at 15000 and now it is at 20000. When you buy in you are saying the price of light sweet crude oil will be at 2000 or more on the date of expiration. If you are correct, you will then receive the set amount of money, usually $100, per contract.

Example of selling a stock with binary options

If you put on light sweet crude oil, believing the strike price of 8000 will be that or less then you will receive $100 per contract if the set amount is such.

However, in both scenarios if you are incorrect and the strike price goes down with a call or up with a put then you will lose all money invested.

Example of buying or selling a stock with binary options long term

You can also call and put with stocks that do not have an expiration, except quarterly. This allows you a few more options. You can always change your mind, however, you will only receive the money you put into the stock.

If you have a contract for Gold in the amount of $80 but now you do not believe the price will be the same or more, you have the option of selling. Of course, you will sell at a loss, but you will not lose your entire $80.

However, if you leave it the same and you were correct in your speculation, you will receive the set amount of money per contract.

You need to watch the binary option price the stock is selling at. This can be a great way to make an educated decision if the stock with rise or plummet on the expiration dates.

Written by Anita Johnston

After hitting an intra-week low of $7.80 last week, Wachovia (ticker: WB) rebounded on the strength of earnings from banks such as Wells Fargo (WFC) and US Bancorp (USB) to close at $12.97. While expectations are certainly extremely low for pretty much all lending institutions, there are significant differences in quality between banks like Wells Fargo and Wachovia. Wachovia’s loan portfolio is of inferior quality, and their Tier One capital ratio is relatively low and continuing to fall despite hugely dilutive capital raises. Until there is a clear sign of the ultimate magnitude of charge-offs and capital needed, you need to be skeptical of rallies in most financials. The October $20 mark on both the Finish High and Finish Low FROs have the greatest open interest; if liquidity allows, I would look to be short the Finish Highs and/or long the Finish Lows.

Likewise, Citigroup (C ) jumped almost 8% Friday after its earnings, despite seeing its North American credit loss ratio up 170%. Citi’s saving grace looks to be its strong increase in net interest margin – or the spread between what it pays depositors and what it makes on loans; cynics might note that this number was once the driving force of bank earnings before we entered the era of highly leveraged structured products transactions. Still, this is a company that had to issue almost $13 billion in common and preferred stock to build its Tier One capital ratio, which is going to hamper future earnings power (per share) due to the dilutive effect. This could make Citigroup a long-term flatliner because EPS growth might not be enough to offset the larger number of shares outstanding, making any options bets I make here tilted toward the bearish side.

Since these two trades would put you net short financials, how to hedge that exposure? One could bet long via Finish High FROs on the S&P Financial Sector (XLF), essentially creating a relative value proposition whereby one expects the index’s higher exposure to the financials I like more (i.e. American Express, 2.75%; Goldman Sachs, 3.58%; JP Morgan, 7.5%; US Bancorp, 2.95%; Wells Fargo, 4.67%) offsets a combined 8.5% exposure to the Wachovia/Citi combo detailed above. Another possible hedge would be to go long the Finish Highs on the S&P 500 (SPY) on the thesis that a recover in the financials – which might put the two short FRO ideas above underwater – would be offset by a broader market recovery.

Read the free Whitepaper on FROs.

Typically, there are two types of binary options: cash-or-nothing options and asset-or-nothing options. A cash-or-nothing binary option pays a fixed, predetermined sum of money providing the option expires in-the-money and nothing otherwise. Asset-or-nothing options return the value of the asset underlying the option.

Binary options can be either put options or call options. Binary call options pay the predetermined amount providing the underlying asset price exceeds the strike price at maturity, otherwise the payout is lost. Similary, binary put options pays the predetermined price if the asses price is trading at less than the strike price.

For example, buying a binary call option for $50 with an agreed payout of $400 will see the option holder receive $400 for every $50 dollars invested, providing the stock is trading above the purchase price of the option at maturity. If the stock is trading below the option price, then the investment is lost. Put options work in the opposite direction, with the option price required to trade below the purchase price at maturity.

Because there are only two possible outcomes of a binary option, they are often suitable for novice investors. However, large-scale financial establishments, hedge fund trustees and other market entities also use binary options as part of their investment portfolios due to their ability to allow traders to tailor their involvement according to market risks. Binary options are often traded by savvy investors and market speculators who are willing to run the risk of making a profit on a short-term contract by taking a stance on which direction a market price will go.

Foreign currency traders and investors might, for example, hedge their risk in currency markets by analysing one currency trend against another to protect against adverse currency movements, whereas traders and dealers of precious commodity metals, such as silver or gold, might seek to hedge their risk against weaker carat pricing.

Other examples of the use of binary options include homeowners who want to cover their risk against weakening real estate prices, and oil companies guarding against crude oil price increases which would represent in increased product costs.

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

Tax Stimulus
Overall, the Obama tax stimulus plan calls for $20 billion to be distributed, but at $300 per family it’ll barely be noticed by the average American family. Small comfort items could be added to the cart that week so it may be time to look into strong grocers like Kroger.

Foreclosure Prevention Fund
Obama’s $10 billion Foreclosure Prevention Fund may be good news for for-profit consumer credit services. His plan calls for ‘pre-foreclosure’ counseling to help families act responsibly when it comes to foreclosure and refinancing.

Tax Preparation Simplification
The concept of simplified tax returns sounds good to a lot of people, everyone except tax preparers. Obama wants Americans to have the option of receiving pre-filled tax forms from their employers. We would only need to verify, sign and return. This move could cut $2 billion in tax preparer fees. Not good news for H&R Block.

Green Technology Investment
5 Million New ‘green’ jobs could be created if Obama gets into office. His plan calls for $150 billion invested over 10 years in next generation biofuels and the infrastructure they require. Look for solid companies making hybrid vehicles, commercial scale renewable energy, low emissions coal manufacturing, and digital electricity grid service providers.

After School Care
Obama’s plan includes expanded after school care for American kids. In addition to doubling the current federal funding for the 21st Century Learning Centers program so that it served a million more children, performance and effectiveness would be monitored. Childcare and educational consultants could profit from new contracts. Look for a company that can consolidate the industry.
Written By: Lela Davidson

Volatility is often used to quantify the risk of an investment, and the value of volatility is expressed in either of two ways: one as a definitive monetary value and the other as a percentage of the mean average value. It is calculated from the annualized standard deviation of an option’s daily change in price. Essentially, if the price of an option fluctuates rapidly over short periods of time, it is said to have a high volatility. Conversely, if the price remains relatively static it is said to have low volatility.

In essence, options which possess high volatility mean their value can change dramatically over a short period of time, either upwards or downwards, while a lower volatility means the value will not fluctuate wildly but rather changes in value at a steady pace across a longer period of time.

Volatility is often used to represent an options uncertainty and level of risk. However, in certain circumstances volatility can be good due to its profit-making potential and short-term traders often buy into volatile markets in contrast to those who look towards long-term buy and hold investments.

Market volatility changes can often warn of impending changes in price trends however it is usually on calculable with any degree of certainty for the past. For traders, however, previous historical volatility trends can give clues to an option’s implied volatility for the future.

-Ancient Chinese Curse

Stress in the financial markets has been spilling over into other areas, affecting equities, derivatives, and a wide array fixed income products. Because of their multiple uses and leveraged nature, the equity derivatives market is an especially interesting point of study, because the behavior of numerous speculators and hedgers is colliding in an increasingly uncertain world. There are a number of unusual developments all options traders need to keep in mind, and I was lucky enough to speak with a contact who works the equity derivatives trading desk at a major investment bank many would call the best on Wall Street. Naturally, most of these also have applications to the regular equity markets as well. A few notes, interspersed with my comments…

One puzzle of the options market lately has been the lack of the VIX making new highs as the broader market makes new lows; typically, the VIX moves inversely to the S&P 500. Perhaps more importantly, the VIX is still relatively low even as broader market volatility seems very high; 2%+ moves have become a frequent occurrence. Why, then, is the VIX 30% off its 52-week high when the S&P 500 is setting new lows, and is 21% below its 52-week high? This has to do with many funds becoming net short the market, and thus not seeking protection via purchasing puts. Instead, they are selling stock – which drives the market lower, but doesn’t send the VIX higher. If you think of the asymmetry presented by institutions being net short, it seems the VIX will move lower more easily than it moves higher, because the likely course of action would be to buy calls to quickly offset short positions.
Taking this a step further, I’ve chronicled a number of indicators of market internals and how far into the oversold area they are getting. The noteable exception was the lack of a blowout in the put/call ratios - but this pretty much explains that. If you’re willing to place a contrarian bet, the oversold levels we’re reaching combined with the big money already being net short may lead to a snapback rally in the equity markets on any positive news.

Earlier options articles on this site note that volatility is a component of an option’s price; by being long a call, for example, one is inherently long volatility. While volatility isn’t at an extreme, it’s noteworthy to point out that speculating on a breakout rally with calls has an added risk – being directionally correct and seeing the markets go up, but having those gains mitigated as volatility falls. Better, perhaps, to use a spread strategy – i.e. bull call – to reduce the net long vega. Also, don’t be afraid to step back from the at-the-money options positions into far-into or far-out-of the-money situations; according to this trader, many professional volatility traders have done so because the huge intraday market swings make it difficult to exercise proper risk management.
Everybody wants to think about making money, but it often pays more to think about how not to lose it.

Phrases most commonly associated with volatility are: degree of unpredictability; extent of uncertainty; range of values within a specific time period.

Volatility refers to the change in value of a financial instrument within a time horizon. It is considered by investors as an important measure of risk when assessing a financial instrument. A stock can have a stock price that grows very steadily at 15% per year. A very similar stock can also have a growth rate that averages 15% per year, but the trend in price may be volatile. That is, growth in year 1 may be 25%, while growth in year 2 is 5%. This variance of 20% between year 1 and year 2 is considered as risk by investors. Thus, all things equal, most investors would consider the first stock because of its predictability, especially long-term investors with a buy-and-hold investing strategy.

On the other hand, volatility can present opportunities to quickly make (and lose) money for short-term traders. Day traders can follow volatile stocks, making purchases at the bottom price point, and shorting stocks when at its peak. Investors with large amounts of capital, such as institutions, often mandate internal controls in place to prevent massive losses. That is, losses (and gains) beyond a certain threshold are capped, and trigger a sale of the financial instrument. Derivative securities such as options and variance swaps allow investors to trade volatility directly.

The majority of stock traders look to the Chicago Board Options Exchange Volatility Index commonly referred to as the VIX to determine the volatility of the market. For the beginner this may seem like a bunch of mumbo jumbo, but if you look at it in layman terms you will understand the concept behind volatility and how, if you decide to trade in this manner, it can affect not only your profits but your loses.

If you just look at the formula that is used to determine the VIX, many individuals including expert stock traders would get a headache.

Let’s leave the headaches to the brainiac’s and get down to basics. 

This formula is used to calculate options on the S&P 500 index. The formula uses both the current price of the underlying security and when the price is not the same as the current price. The majority of the time the stocks that are used are ones that are closest to expiration. Using this formula, analysts will estimate or predict the volatility of a hypothetical option on the S&P 500 index that is within 30 days of expiring.

Now, on to understanding all the figures that are thrown at us. The VIX is given to us as a percentage of what the S&P 500 Index will do in the next 30 days. An example would be whatever the percentage is given, the options market believe the S&P 500 Index will move in one direction or the other during the next month.

What may be very confusing is that the VIX does not move with the stock market. Normally, when the stocks are falling you will notice a rise in the VIX. During good financial health, the VIX goes down. However, this is not in granite, remember it is the stock market and anything can happen.

As you begin trading and watching the VIX, the majority of the time if the VIX is 25 or lower the market is in stable condition, but as the VIX goes up traders realize trouble is forthcoming.

Investors seem to work off a fear factor. Such factors as terrorist attacks like September 11 put fear into the minds of investors and you are sure to see a VIX in the bullish range of 30 or above. However, this can be good for the cool-headed investors that realize these problems usually level out rather quickly. The cool-headed investors jump into the pot at full steam even if the market seems a bit bullish.

The VIX only uses the S&P 500 index; however, you can also use the calculations of NASDAQ – VXN, Dow Jones – VXD, and American Stock Exchange – QQV along with a few others. These are not used as often but can still give you an idea of more than one formula and the estimations that come from each exchange to give you a better understanding of the volatility that might be present.

Learning to use the Volatility of the market to see farther into the future and to explore other markets and individual sectors can mean the chance for more gains, but it can also mean large losses.

By Anita Johnston