Conventional options are the most heavily exchange-traded option, yet
volumes rarely exceed that of the underlying future with one or two
exceptions (e.g. the Kospi index). This can be partly explained by the endusers’
reticence in using a complicated instrument, but the major constraint
is the reluctance of brokers to offer accounts to many customers who may
not be capable of sustaining the potential losses that can be incurred from
losing positions. These losing scenarios will always be predicated on the
naked writing of options that occasionally explode, leaving the short with
a potentially limitless, unrecoverable debit on his account.
In contrast to the above high-risk situation, the binary option enables all
potential losses to be calculated on the inception of the trade, since the
price of a binary option is constrained by the limits of 0 and 1. As we will
see later, writing (selling) a binary call has the identical profit & loss (P&L)
profile of buying the same strike put of the same series. On selling an
out-of-the-money call at 0.2 (equivalent to a 4/1 bet) the seller’s maximum
loss will be at 1.0, where he will lose four times the amount he sold.
Clearly the broker is likely to have less unease in opening accounts for
clients with this scenario; and if the broker insists on 100% upfront
payment of the maximum potential loss, then the broker’s potential
liability is now totally covered.
2 Clearing and Settlement
A major constraint on starting and operating a derivatives exchange is the
necessary cost of engaging a clearing house. The Eurex and the Chicago
exchanges operate their own clearing houses, which require huge sums
of cash in order to operate their exchanges with financial integrity. Clearly
binary options alleviate this cost since the risk management is a more
exact methodology. This is likely to lead to a proliferation of binary/betting
exchanges globally.
3 Regulation
Regulatory authorities are placed between a rock and a hard place over
the regulation of binary options exchanges. The nature of the risk involved
means that these exchanges will distribute binary options via the internet
in much the same way as eBay offers everything but bets via the internet.
If regulation in any one jurisdiction becomes overburdensome then the
exchange will up sticks and go offshore.
It is clear that the ability to distribute the product cheaply over the internet
will be a major advantage to the exchange and the binary option
user/trader. The combination of a homogenous, limited-risk instrument
with zero credit facility ensures zero account defaults.
Leverage
The nature of binaries changes sharply as expiry nears. Shares and futures
have linear P&L profiles that lie at a 45º angle to the horizontal axis.
Conventional traded options have profiles that approach an angle of 45º.
A 45º angle means that if the share/future/option goes up by 1¢, then the
owner makes 1¢. A binary approaching expiry has a P&L profile that can
exceed 45º (indeed it will approach the vertical for an at-the-money
option) meaning that a 1¢ rise in the underlying share could translate into
a multiple (say 5¢) increase in value of the option. Clearly this feature is
likely to attract the player who is looking for short-term gearing, for it is
safe to state that a binary option can provide greater gearing than any
other financial instrument in the marketplace.