An Introduction to Binary Spread Options

binary spread optionsBinary Spread Options are the limited risk version of Spread Trading, yet Binary Spread Options offer much higher gearing.

Binary Spread Options aka Binary Pairs enables the speculator to back the view that on a certain date in the future the price of asset 1 will be K higher or lower than the price of asset 2. The target difference K thus assumes the role of the strike price and is independent of the overall levels of the two asset prices.

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A strike price of zero then indicates that one asset must have a higher price (if call) than another asset; conversely, if the binary spread is a put then one asset must have a lower asset than another. Immediately one can glean that binary spread options have a great deal in common with vanilla binary options in that a binary spread put option is 100 less the same strike binary spread call option.

Binary Spread OptionsNo. of StrikesPayoutSettles
Binary Spread Call Options10:100At Expiry Only (European)
Binary Spread Put Options1100:0At Expiry Only (European)
Binary Spread Eachway Call Options2100:40:0At Expiry Only (European)
Binary Spread Eachway Put Options20:40:100At Expiry Only (European)
One-Touch Binary Spread Call Options1100:0At Any Time Prior to Expiry
One-Touch Binary Spread Call Options10:100At Any Time Prior to Expiry

Binary Spread Options v Futures Spreads

Most derivatives traders have conducted a spread trade at some point in their trading career; these spread trades generally are futures trades and the most common are the spreading of one short-term interest rate month against another month of the same contract, e.g. sell 1 Dec Eurodollar 98.30, buy 1 Mar Eurodollar 98.35. If the spread widens the seller gains by $25 per spread per tick profit.

If the current spread is trading at -5 and a binary spread has a strike of -5 ticks then the price would be roughly 50. Should the spread widen from -5 this would generate a settlement price of 100, in effect roughly doubling the speculators money. Therefore in terms of a straight comparison between a futures spread and a binary spread, the latter can provide significantly higher gearing along with a limited risk scenario.

Applications

Binary spread options have applications wherever spread trading is currently being undertaken. Clearly there is no need for the two assets to have any correlation but it is generally common for spread traders to operate with assets that do have positive correlation.

i.            Interest Rate Futures

Probably the highest volume of spread trades takes place between interest rate futures with traders operating down a specific currency curve or between different currency curves.

Short-term interest rate futures, e.g. Eurodollars, Euribor, Short Sterling, Oz 90-Day Bills, EuroSwiss are home to spread traders trading one month against another. Spreads, butterflies and condors are all spreading strategies within this market so subsequently it would be perfectly feasible for there to be binary spread options in these markets.

It is not unusual for traders to trade same currency 2, 5 and 10 year bonds against each other, while a more risky trade might be spreading the Bund against the US 10 year Note. In the 1990s when Italy was joining the Euro convergence took place and funds actively traded Italian BTP calls against Bund calls, so this would be a clear example where binary spread options could be applied.

ii.            Stocks and Shares

Trading that one company outperforms another is a traditional form of spread trading. The shares are generally in competing companies and within a specific sector so the correlation is positive.

iii.            Commodities

Oil is an obvious potential candidate for binary spread options with trading of the ‘crack’ spread already prevalent. This involves the trading of the price of oil between two levels of the production process.

iv.            Shares v Commodities/Shares v Indices

Trading gold company shares against bullion has been a long-standing play, as to has trading a share in an index against the index itself. Both are forms of hedging based on the fact that the pair of assets will have positive correlation.

v.            Reverse Yield Gap

This spread has a negative correlation and is based on the yield of an index of shares against an interest rate.

All the above examples would be potential candidates for binary spread options. The advantages as ever revolve around the limited risk scenario of binary options plus the fact that binary spread options would need just one margin call, as opposed to the two margin calls of the Bund v US 10 year Note spread.

Summary

There are now binary spread options platforms trading on the internet which probably underlines their relative simplicity, practicality and commerciality. These platforms, as with the current crop of internet-based binary options platforms, offer very short-term strategies. It is hoped that this section will broaden the readers outlook as to the potential uses, trading opportunities, pricing and risk management techniques so that when longer term binary spread options become available the reader will be able to form more knowledgeable assessments as to the fair value of a binary spread strategy.

Above under ‘Applications’ markets were discussed where traders are offsetting one future against another in the hope of gaining a profitable edge. In effect these traders are doing nothing but trading the correlation coefficient. Binary spread options offers the binary options trader to make a critical judgement on the price of the strategy in the marketplace by forming solid and researched views on the volatility of the individual assets. This implied volatility assessment is likely to be influenced heavily by the implied volatility of the individual conventional options of each asset.

Binary spread options offer a new dimension to the market; in effect they are not ‘reinventing the wheel’ as spread trading is already in existence. What these binary strategies offer is the ability to get involved in these markets with limited downside risk plus only one initial margin call or premium charge.

Furthermore, since spreading the underlying requires brokers for two individual ‘legs’ the cost of trading binary spread options and binary spread eachway options is likely to be relatively cheap also.

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