binopt

Issue #44

Last Update March 2, 2006

Business and Finance Binary Options by Sten Grynir April 18, 2005 At the Futures Industry Association annual conference in Boca Raton in March, Hedgestreet and The Clearing Corporation announced an agreement in which Clearing Corp will handle the clearing of HedgeStreet trades. HedgeStreet is a registered derivatives exchange that specializes in “hedgelets”, small-sized options for reducing risk on real world events. One of its primary products is the binary option, also known as an “event option”, which allows the hedger/investor to bet on the occurrence or non-occurrence of an event. At the same conference, the Philadelphia Board of Trade (PBOT), the futures trading subsidiary of the Philadelphia Stock Exchange, announced the start this summer of trading in event driven options on its electronic exchange.

In normal options, the trader buy or sells an option on some underlying stock, commodity or futures contract, paying a price (called a premium) for that option. The option is the right (not the obligation) to buy the underlying asset (if a Call option) or sell the underlying asset (if a Put option) at a specified price, called the strike price. The option expires at a particular date (called the expiration date). If the market price of the underlying asset goes above the strike price for Calls, or below the strike price for Puts, the option is “in the money”, and will be increasingly profitable for the trader who bought the option as the difference between the market price and strike price increases. If the option is “out of the money”, there is no profit for the trader, but the trader's loss is limited to money already paid, i.e. the premium.

In a binary option, the underlying asset can be an event (So and So is elected President) or a price point being attained (oil prices will reach $60 per barrel, or the Dow will fall to 9000). If that event occurs or that price point is attained, the holder of a binary option will received some fixed amount of money. Note that the reward to the option buyer is unaffected by the amount by which, in our example, oil prices exceed $60. This is, in effect, an all or nothing bet. The option premium then actually represents the investor's view of the odds that the event will occur. HedgeStreet is careful to avoid the use of the terms “bet”, “odds” and “winnings”; as a regulated exchange, they are eager to avoid being mistaken for a gambling enterprise. Their mission is, in fact, to bring the advantage of hedging instruments, previously only available in large denominations, to the retail market.

Currently, HedgeStreet is offering binary options trading in economic indicators, employment indices, the Consumer Price Index, oil and gas prices, precious metals, currencies, the Fed Funds rate, and 1-year and 30-year mortgage rates. While not ruling out the eventual addition of things like election results, HedgeStreet is concentrating on relatively traditional financial areas. PBOT's options are in economic indicators, equities, interest rates and agriculture.

Several issues with regard to these instruments were raised at the FIA presentations. Since economic indicator figures for a given month are often revised several weeks after they are published, PBOT and HedgeStreet have adopted the policy that options pay off on the initially announced figures, however poorly that may accord with the reality displayed by subsequently revised numbers. They are also steering clear of options on events that might be easily manipulated (individual corporate earnings, mergers and acquisitions, etc.).

More information can be found at www.hedgestreet.com and www.phlx.com