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.
Dexterity
At present financial fixed odds betting suffers from a paucity of available strategies compared with conventional options. Spreadbetting companies’ binary offerings are usually restricted to the regular upbets, downbets and rangebets in regular or one-touch/no-touch mode; but this is very plain fare in comparison to what’s available on the high table of the OTC market. Knock-Out bets, Knock-In bets, Onions and bets on two separate assets are all available and over time are likely to, with one handle or another, enter the trader’s vocabulary. Of course the trading community will require educating in order that they may use these instruments proficiently, but this is standard in all new markets. Once the trading community has a clearer understanding of binaries, there will no doubt be increased pressure on mainstream exchanges to issue binaries on their current products – with the CBOT’s introduction of a binary on the Fed Funds rate the process has already started.
Product Sets
When considering binary options, the usual product revolves around foreign exchange bets and, more recently, bets on economic data and the aforementioned Fed Funds rate. Earlier in this introduction sports bets were proffered as alternative forms of binary options, but the product set need not end there. Bets on political events are prevalent particularly at the time of elections. Furthermore, the media is increasingly becoming a sector where wagers may be placed. Reality TV events are now widely accepted as a betting medium, but there is no reason why this should not be extended to, for instance, the film industry. Binary options on weekend cinema box office takings would no doubt be a welcome hedge for film producers and nervous actors.
Summary
Although this book steers clear of complex mathematics, it systematically analyses the anatomy of fixed odds bets. Hopefully this book will:
l allow the part-time punter to learn enough to eradicate amateurish mistakes;
l open up the financial and commodity fixed odds market to the sports betting enthusiast; and
l provide enough material and new concepts for the professional binary options trader to, at the very least, look at combining different forms of financial instruments with binaries in order to maximise potential profits and minimise unnecessary losses.
Section I
This section introduces the reader to the two basic bets, the upbet and the downbet. These two bets are arguably the foundation for all financial engineering since any instrument can be broken down into a multiple of upbets or downbets.
In chapter 1 the reader is initially introduced to the concept of when bets are winners and losers using random walk illustrations and P&L graphs.
Chapters 2 through to Chapter 4 inclusive are concerned with how upbet and downbet prices change owing to changes in the price of the underlying, changes in the volatility of the price of the underlying, plus time decay. These sensitivity analyses are known as the ‘greeks’ in options parlance.
1. Upbets & Downbets
1.0 Introduction
An upbet can only win or lose at the moment the bet expires and not at any time leading up to the expiry of the bet.
Examples of upbets are:
1. Will the price of the CBOT US Sep 10 year Notes future be above $114 at 1600hrs on the last trading day of August?
2. Will the Dow Jones Index be above 12,000 at 1600hrs on the last trading day of the year?
3. Will the LIFFE Euribor Dec/Sep spread be above 10 ticks at settlement on the last day of November?
4. Will a non-farm payroll number be above +150,000?
Examples 1, 2 & 3 enable the bettor to make a minute by minute assessment of the probability of the bet winning. Example 4 is a number (supposedly) cloaked in secrecy until the number is announced at 13.30 hrs on a Friday.
In all the above examples the bet always has a chance of winning or losing right up to the expiry of the bet although the probability may be less than 1% or greater than 99%. The Notes could be trading two full points below the strike the day before expiry but it is possible, although highly improbable, for them to rise enough during the final day to settle above the strike. Conversely the Notes could be trading a full two points higher than the strike the day prior to expiry and still lose although the probability of losing may be considered negligible.
Ultimately the upbet is not concluded until the bet has officially expired and until then no winners or losers can be determined.
Downbets too can only win or lose at expiry. Although in many circumstances the downbet is simply the reverse of the upbet, the downbet has been treated with the same methodology as the upbet in order that other bets, e.g. the eachwaybet, can be analysed within a uniform structure. Also a separate treatment of downbets will provide a firmer base on which to analyse the sensitivity of downbets.
1.1 Upbet Specification
Fig 1.1.1 presents three different random walks that have been generated in order to illustrate winning and losing bets. All the upbets start with an underlying price of $100, have twenty-five days to expiry and a strike price of $101.
1. Random Walk 1 (RW1) flirts with the $101 level after five days, retreats back to the $100 level, rises and passes through the $101 strike after eighteen days and then drifts to settle at a price around $100. The buyer of the upbet loses.
2. RW2 travels up to the $101 level after the eighth day where it moves sideways until, with nine days to expiry, the underlying resumes its upwards momentum. The underlying continues to rise and is around the $102.75 level at expiry, well above the strike of $101, so is consequently a winning bet with the seller ending the loser.
Figure 1.1.1
3. RW3 drifts sideways from day one and never looks like reaching the strike. RW3 is a losing bet for the backer with the underlying settling around $100.50 at expiry.
1.2 Upbet Pricing
Fig 1.2.1 illustrates the expiry price profile of an upbet. One of the features of binaries is that at expiry, bets have a discontinuous distribution, i.e. there is a gap between the winning and losing bet price. Bets don’t ‘almost’ win and settle at, say 99, but are ‘black and white’; they’ve either (except in the case of a ‘dead heat’) won or lost and settle at either 100 or zero respectively.
1. If the upbet is in-the-money, i.e. in the above example of Fig 1.1.1 the underlying is higher than $101, then the upbet has won and has a value of 100.
2. Alternatively if the upbet is out-of-the-money, i.e. the underlying is lower than $101, then the upbet has lost and therefore has a value of zero.