Discussion in 'Options' started by marketsurfer, Jul 2, 2008.
Great article Pabst!
Speculative Trading with Binary Options
I own Al Gore.
I don't mean I own Gore figuratively as on the basketball court but rather I own Al Gore literally. I'm long Al Gore for President on Intrade. Now please don't take this as a political endorsement. I'm probably best described as a libertarian Republican. To someone like me who trades professionally and also ran for Congress a few years back, Intrade is a marriage made in heaven. Even if you have little interest in trading on political events Intrade is an excellent forum to learn how to price binary options.
Intrade is an exchange based in Dublin. Although Intrade is legally recognized in Ireland it's legality with U.S. citizens is murky. However since the CFTC has allowed the University of Iowa to also list an election market and because Intrade didn't stop me from opening an account even after realizing I'm an over regulated American, it's possible that Intrade might pass muster with the DOJ.
If my future bylines are from Federal penal institutions in Leavenworth or Talladega then perhaps you should shelve the idea of opening your own Intrade account.
Intrade is best known to American handicappers by it's sister site, Tradesports. Founded in 2000 Tradesports is regaled for offering two sided binary markets on sporting events. Intrade specializes in Prediction Markets ranging from election results to hurricane forecasts.
Unlike a traditional bookmaker where one trades against the house, speculators on TradesportsandIntrade trade directly with other participants in the same manner one would trade on any other futures or options exchange. In fact Intrades order entry system is a DOM price ladder resembling a poor man's version of Trading Technologies X-Trader.
A binary option is an option type that at expiration either pays off a fixed amount or nothing at all. Let's say XYZ is trading at 95 and the 100 binary call option is offered at $2 with a fixed payoff of $10 if the stock closes above the 100 strike. Below 100 at expiration you lose your entire $2 and above 100 at expiration you make $10. Simple. One or the other. The option pricing model is merely the odds of whether XYZ will close above the 100 strike or not.
A typical vanilla options model assumes the smallest payout is just above the strike while a binary pays off equal no matter how much it closes in the money. Also, because a binary waits until expiration to pay out it's full 100% a binary views time decay much differently than a vanilla call.
As you know the value of an ITM option is the sum of it's intrinsic (price above the strike) and extrinsic (time) premium. In a hypothetical no cost of carry basis the extrinsic value of an ITM call should be of equal price to the same strike/expiration OTM put. An example:
Thus a normal call option enjoys it's greatest relative value when it has the most time left. A binary is the exact opposite. Which of the following outcomes is more certain? If XYZ is 105 today it'll be greater than 100 one year from now or if XYZ is 105 today it will be greater than 100 tomorrow? Clearly we have a higher expectation of XYZ being above 100 with just a day left than with an entire year in front of us.
Hence with XYZ at 105 a binary 100 call expiring tomorrow would be trading at virtually a 100% chance of being above it's 100 strike and the 100 call a year out might only be priced at a 60% chance.
While binary options are offered on many OTC currency and fixed income platforms the only exchange traded binary contract is on the CBOT's Fed Funds contract. A binary option trades at prices between 0 and 100. The auction traded "price" is essentially then the percentage chance of the full payoff being achieved at expiration.
A price of 5 on a binary option means simply that participants collectively believe there's a 5% chance of the binary closing in the money at full payoff. In the future U.S. Exchanges will continue to expand the development and listing of binaries. Even if you don't open an account on Intrade or Tradesports, gaining knowledge of how binary options operate in real world environments will give one unique insight in assessing market probabilities.
As far as my Al Gore trade; not looking so good. I paid between $0.40 and $0.50 (for a $10.00 payoff) and Gore is now offered at under $0.10 and he's probably on his way to zero.
Figuratively speaking of course.
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