Binary Options: Win or Lose?

Last week, CNBC announced that the Chicago Board of Options Exchange (www.cboe.com) will begin offering binary options on the S&P 500 and the volatility index (VIX) on July 1st. Now binaries have been used in the currency markets for some time, but they're relatively new to the stock market. The first binaries were introduced on the AMEX on May 5th, less than two months ago. So what are they and why would an investor want to play them?

Binaries are Fixed Return Options
A binary or fixed return option (FRO) is an all-or-nothing bet, just like betting on a horse. If Old Nelly wins, the amount you receive is the size of your bet times the odds. If the nag loses, you're out the cost of your bet. That's exactly how an FRO (as binaries are called on the AMEX) works. The FRO term for a call is Finish High and Finish Low for a put. Both types of options can be bought or sold, just like a regular option, but unlike regular options, binaries aren't subject to implied volatility and to a lesser extent, time decay which make them easier for the novice investor to understand. Because they're tied to an underlying security or index, FROs can be traded through a regular broker, although most require at least a Level 2 designation on your account. (FROs can be traded in retirement accounts as well.)

All binaries are of the European type meaning that they can only be exercised on the last day of trading before expiration, typically the third Friday of the expiration month. At expiration, the options holder (buyer) will receive $100 per contract if the price at expiration is at or above the strike price for calls (Finish High options) and at or below the strike price for puts (Finish Low options). An options seller will get to keep the premium collected on the option if it expires out of the money, but will be forced to pay $100/contract if it expires at or in the money. The maximum loss that an options buyer can incur is the cost of the initial transaction (plus commissions), and for the options seller, his maximum loss is ($100 - initial premium taken in by the sale) x the number of contracts. Contrast this capped loss with the theoretically unlimited loss of selling a naked standard options call and you can see why using binaries for this type of trade are a lot more desirable.

Binary options use a cumulative distribution function to determine their value instead of the Black-Scholes formula used to calculate the price of standard options. A good rule of thumb in determining the price of a binary is to use the value of delta on the corresponding standard option. For example, an at-the-money call will have a delta of 0.50 which should be the price of the binary. Deep in-the-money calls will have binaries priced near one, and those far out-of-the-money will have binary prices close to zero.

Currently, the AMEX offers FROs on 20 of the more widely-held and heavily traded stocks and ETFs, including AAPL, C, CSCO, DIA, EEM, GE, GOOG, GS, HD, IBM, INTC, IWM, JPM, MSFT, OIH, QQQQ, SPY, WB, XLE, and XLF. (See www.amex.com for the list and their corresponding FRO options chains.) Most of the above stocks come with strikes up to three months out; some come with strikes up to a year away. Checking through some of these option chains, I found that most of them are thinly traded (not uncommon for a new product) and come with astronomic bid/ask spreads. For example, the spreads on the SPY are 15 cents, and a July at-the-money strike has an open interest of only 20.

One cause for concern is the settlement pricing of these options. To prevent large investors or institutions from artificially manipulating the price of the underlying stock or ETF on expiration day, the AMEX does what is called VWAP pricing on their FRO products. Now we looked at the VWAP, or volume weighted average price, in a previous blog and saw that it's nothing more than the total value of all trades made during a certain period (here the period is one day) and dividing it by the total number of shares traded. Although VWAP pricing can remove some price manipulation, I don't know if it can remove all of it, especially on the more thinly traded stocks and ETFs.

The Upside to Binaries
The upside is that binaries are a lot easier for the casual investor to understand--you either win or you lose, it's that simple. They're also cheaper than standard options since their prices are capped at $100/contract making them affordable investment tools for the small investor. Another advantage is that you can buy them without worrying that you're paying a premium arising from inflated implied volatilities. In fact, in times of high volatility the binary may be the preferred choice for the options holder (buyer). Also, hedgers can use them in place of a covered call to avoid giving up any upside price movement. If you think that the underlying might expire within certain price levels, you can construct binary spreads to take advantage this.

The Downside to Binaries
The newness of these products gives rise to liquidity issues as well as to large bid/ask spreads, but increased product interest should mitigate these factors. One major downside to binaries is that your profit is capped. If you happen to be right, you might be kicking yourself for not buying a regular option instead.

Conclusion
Since binaries are such a new product, I haven't had much time to digest their significance and possible uses. I can't say right now if they make attractive additions to everyone's portfolios but I do think that they might afford some cheap catastrophic insurance to those holding large positions in one of the above mentioned stocks or index ETFs. The coming months will surely tell if binaries are viable or not. Stay tuned!