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First published in Great Britain in 2008
This eBook edition 2011.
Copyright © Harriman House Ltd
The right of Hamish Raw to be identified as the author has been asserted
in accordance with the Copyright, Design and Patents Act 1988.
978-0-85719-126-7
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Acknowledgements
To Professor Desmond Fitzgerald for introducing an itinerant truck driver to options theory. To Mark Levy and Danny Smyth, two of the slowest option pit traders I have ever had the pleasure of trading against, for reading through the manuscript and checking for glaring errors. To Stephen Eckett of Harriman House for direction. And finally to Cameron, Roxanna and Gabriella for persistently badgering their dad to finish the book.
Introduction
Overview
As betting markets become more and more sophisticated (epitomised by the advent of specialist sports hedge funds) the crossover between sports betting and financial trading will intensify. Already futures trading by way of spreadbetting has become established in the sports betting market, while in turn fixed odds bets, by way of binary options, are being increasingly used for speculating in the financial and commodity markets.
Binary options (aka financial fixed odds bets, aka binary bets) have a number of characteristics which will enable them to become the most heavily used and popular derivatives instrument. They provide:
1 easy access for the trader via the internet;
2 a limited risk environment for all participants;
3 at expiry greater gearing for the speculator than, for instance, futures, CFDs, spreadbets or conventional options;
4 a far greater degree of flexibility enabling the sophisticated trader to customise his bet to take full advantage of accurate forecasts;
5 a product range that ranges from financial and commodity instruments to sports, political, media and weather; and finally
6 they are tax-free in many jurisdictions.
Binary options are used by people in many countries, albeit under a different name – that of a fixed odds bet. Nowadays many nations have their Kentucky Derby, Breeder’s Cup, Grand National and Melbourne Cup, which attract wagers from a broad range of people; and recently betting on ‘reality TV’ events has become popular. All these betting participants are (unwittingly) buying binary options, and the flexible nature of this instrument will enable it to pervade the lives of many of whom are already avid sports punters but have always shied away from participating in the world of sophisticated financial instruments. Henceforth the term fixed odds bet will be interchangeable with the term binary option throughout this book.
Distribution
Hitherto, if one ignores fixed odds sports betting, binary options have been very much the preserve of the financial OTC (over-the-counter) market. Financial and commodity derivatives markets generally restrict themselves to offering futures and conventional options while the stock markets offer shares only. One must suspect the omission of binaries from derivatives markets has been an oversight, while from stock exchanges one suspects an attitude bordering on snobbery owing to the speculative nature of the instrument. Whatever the reason, these exchanges are likely to watch in awe as the trading volumes on binary/betting exchanges soar.
What are the grounds for such an assertion?
The following points explain why this instrument will see the same exponential growth that futures/options exchanges did throughout the latter half of the 1980s and most of the 1990s. The basic tenet springs from the fact that since binary option positions create a quantifiable maximum downside risk, this results in:
1 Risk Management
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 end-users’ 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.