Is there a substantial interbank/brokerdealer market for short-dated digital (binary) options on equity indices? I was wondering how a larger dealer like igmarkets would be hedging their risk typically or if they just warehouse it like a casino would.
It's much simpler. A binary option is perfectly replicated via a call spread, that's how a dealer hedges. The bid/offer on the digital is determined by the width of the call spread and the direction of the barrier shift.
so your saying that a binary is exactly a call spread but more expensive because they are making a spread between them buying a call spread and them selling you a binary.
Well, they are pricing a digital by pricing a tight call spread, but don't always hedge it. When I was running an exotics book, I would only hedge really large digital risk (e.g. 100m in size) and smaller stuff I would just throw into the book (it is actually booked as a call spread) and delta-hedge. Oh, nobody exactly replicates each and every tiny digital, that would be silly. The market maker trades them and hedges delta, if the call spread width is wide enough, you will statistically make money. However, if digital risk on any strike is too high, we can always offset it in vanilla options, not necessarily of the same maturity.
Yup. It's no different then delta-hedging a call spread, you end up short gamma when it's OTM and long gamma when it's ITM.
If a client were to let's say open multiple accounts legally and max out (100k digital per account) a pin risk at a specific daily binary strike, do you think that the dealer would be within its rights to amend/cancel the trades? I am wondering how this would generate feedback into the options markets if it is done across several binary dealers at once. Some of these binaries on equity indices don't even have liquid listed options markets...
They monitor P/L on each market and increase the bid/ask spread until it is profitable for them. Binaries started out many years ago with smallish spread, about 2%, now some markets are 6% and some even 9% wide. They also know who they are betting against and will back away from their prices if a big punter with a profitable history tries to hit them in a fast moving market. So no hedging but they rely on a few dirty tricks to ensure they are profitable at market making these instruments.
same in illiquid small securities.. the bid/ask spread is so wide that your on a very short shoestring.. and alot of edge is lost because of the difficulty of hedging for the market maker.. i need some dirty tricks!