binary options

What Are Binary Options?What Are Binary Options?

It is doubtful whether there has ever been a capital markets instrument that has had as much tosh written about it as the enigmatic binary option. The internet has been flooded with articles written by low quality ‘content writers’ lauding the simplicity of the instrument accompanied by ‘call-to-action’s. Unfortunately some of these ‘call-to-action’s have been along the lines of “Enhance Your Pension” and other such irresponsible marketing that has given the binary options industry a bad name in some quarters. So exactly what are binary options?

Binary Options Regulation

One of the main problems when considering the regulation of binary options is defining what a binary option actually is. Unfortunately for the regulator, as the below will explain, this is tantamount to asking how long is a piece of string.

Only when a workable definition of a binary option is generated can the instrument be successfully regulated.

A Possible Workable Definition

A binary option is a derivative that:

  1. is based on the price of a capital market or insurance market asset
  2. has a payout bound by 0 and 1 inclusive, or multiples of 10 thereof.

A seemingly nice and simple definition one may think yet the following will all confuse the issue:

  • underlying asset
  • price format
  • time to expiry
  • payout
  • risk
  • the user interface itself.

All Capital Market Instruments are Binary Options!

Any other capital market instrument can be replicated by a structure of vanilla binary options, i.e. all capital market instruments could be viewed as binary options. Far fetched? There is a direct corollary in computer software. The software languages that are more readily known to us and that can be seen under the ‘Computing’ shelves of a bookshop, e.g. VBA, C, Java, Ruby or Erlang are all user-friendly manifestations of machine code, the basis of which are the binary numbers 0 and 1.

A conventional option can be replicated by a structure of vanilla binary calls and so can a conventional call spread as attested by the IG Group’s Nadex. The CFTC are happy with Nadex’s interpretation of a conventional call spread in the guise of a binary options strategy, yet this is just the tip of the potential iceberg.

A limit-up, limit-down future can be replicated by binary options. Furthermore, a barrier option itself is a ‘Yes’/’No’ event thereby dragging the most sophisticated market of all, the interbank FX market, into the realms of binary options trading.

Unless the regulators of binary options understand the reach of binary options within the capital markets industry the regulator is likely to create confusion which in itself could possibly lead to regulatory arbitrage.

The following are elements that could, and possibly should, impact on the regulation of binary options.

The Underlying Asset

The likeness between a bet on a horserace and whether gold will be above or below a particular price in the future are obvious. The first part of the above ‘A Possible Definition’ puts a clear limit as to the boundary of a binary option and differentiates between a fixed return bet on, for example, a sporting event and a capital market event.

The insurance market has been included since an Industry Loss Warranty (ILW), generally a vanilla binary option, is already a well-established and accepted derivative primarily traded between the insurance and reinsurance companies.

In the US the scope for trading derivatives on film industry box office receipts has been examined. At present the underlying asset has been rejected by the CFTC although for the film industry itself the hedging process offered by these specific derivatives has clear commercial value. In the future what may or may not be considered a capital market asset could of course be changed.

The Payout

The Nadex interpretation that a binary option can settle at any price between and including 0 and 1 (and multiples of 10 thereof) has created a powerful precedent.

On mainstream derivatives exchanges the ratio of the volume of conventional vanilla call and put options is possibly just 20% of the total volume, the other 80% taken up by conventional options strategies such as call and put spreads, straddles, strangles, butterflies, condors, etc.. It is likely that as the binary options market develops then structures of binary options will rule the roost also. Should that be the case then the CFTC view of a binary options should be upheld, i.e. a binary option strategy does not need to settle solely at 0 or 1 can be allowed to settle at any intermediate value as well.

Price Format

The price constraints of the binary option’s 0 and 1 are often (quite rightly) equated to the probability of the event happening or not.

All sports bookmakers and betting exchanges offer odds based on the numbers between 0 and 1, inclusive. The word ‘Evens’ equates to the binary options price (probability) of 0.5. In a similar manner the odds 4/1 equates to the binary options price of 0.2, while 6/4ON equates to a binary options price of 0.6.

For retail customers on the internet binary options are often presented in a percentage return format so the binary options price of 0.5 would be presented as a 100% return investment.

Continental prices (those offered by, for example, Betfair) would show a price of 3.0 for a binary options price of 0.3333, while showing a price of 2.0 for a binary options price of 0.5.

Binary options providers often multiply the 0-1 binary options price format by 100 so that the payout is now ranging between 0 and 100 inclusive.

The critical features of the price format is that they are:

  1. bound by a representation of 0 and 1 inclusive, and
  2. understood by the end-user.

If the non-mathematician is more comfortable investing at a price of 4/1 (as opposed to 0.2) that the FTSE will be above a certain price then that price of 4/1 should be allowed to stand as the alternative could well be that the non-mathematician invests at a price of 0.2 they do not understand.

Time to Expiry

The short-term nature of the length of contracts of the internet-based retail binary options has generated a certain amount of ill-founded comment that this alone renders the instrument a gamble, a bet, as opposed to an investment.

Firstly, as an ex-pit trader on LIFFE, CBOT and the SFE I have been able to watch the extraordinary capability of certain ‘local’ traders (independent traders trading with their own money) to forecast ultra short-term movements. When the exchanges went electronic these traders were replaced by a new breed of ‘local’ who sat at a desk watching price movements, or ‘price action’, on a screen. I did not have this ability (I was a ‘local’ options market maker) so what may have been a gamble to me was a ‘nailed on cert’ for these other guys.

Nowadays the markets are dominated by High Frequency Traders using ultra fast algorithms and execution to take and exit positions in the market. These operations can enter thousands of different orders across a range of different assets only to reverse them all within seconds. Across the globe regulators view these actions as investing, not gambling.

The current short-term nature of retail binary options should not be jeopardized by enforcing a rule (such as the Japanese FSA has done) of creating a minimum length of contract (one hour in Japan) that serves no real purpose at all. If the JFSA were questioned on this limit of one hour one might wonder what their rationale was.

Risk

An expert in the field of gambling regulation recently proposed to me that binary options were gambling because of the limited risk aspect of the stake purchased which, in effect, was pursuing an argument that the premium was much the same as a gambler’s stake, it could all be lost. This argument is clearly flawed by the fact that a buyer of conventional options would also be gambling and therefore conventional options should fall under a betting regulator as opposed to a financial services regulator.

Not one of the binary options providers took a hit in the recent Swiss/Euro debacle in January while notable names, such as the IG Group, took a sizeable battering on their non-binary offerings. Since the UK taxpayer underwrites the clients of UK FCA regulated firms (via FSMAs Financial Services Compensation Scheme) there is good reason for the FCA to ensure that all firms have adequate resources to take a hit; yet overly punitive capital adequacy requirements for limited downside risk binary options companies will likely be counter-productive as companies determine to be offshore, thereby resulting in unregulated entities and the loss of revenue to the UK from these outfits. (The UK’s FCA has been used as an example as they are in the process of delivering regulation on binary options but the tenet of the argument applies to all mainstream onshore financial regulators.)

User Interface

Innovative trading interfaces are constantly drip-feeding onto the financial markets as designers compete to come up with the most attractive compromise between ease-of-use and providing sufficient market data. What if a designer came up with a radical new interface whereby the market is traded in the form of a cricket match or a game of snooker? How about a casino-themed interface to trade the market? If the underlying asset of these ‘themed’ sites is still a capital market asset is that sufficient to determine that it is a binary option or is there a predetermined notion that a binary option has to be offered in some more traditional (tired) manner?

Say I wish to offer binary options in the form of a game of seesaw? At-the-money calls and puts can easily be presented in this dynamic, graphic format. Is this depiction of a capital market asset gambling?

Conclusion

The regulation of binary options is going to be challenging, especially should regulators decide that the simple definition of a binary option does not fall into line with that proffered earlier in this article.

The current purchase of Plus500 by Playtech is underscored by the blurring of the demarcation between capital markets and the gambling markets. The fact that Betfair offers some financial bets as well as sports bets is yet another example of these two sectors treading on each other’s toes.

In the UK, if the FCA gets this regulation right then it would almost definitely be the first port of call for binary options operators that are looking to play with a straight bat. The FCA’s approach could well be the shake-up the European binary options so desperately needs.

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