BINARY ECONOMICS:
HOW TO TRADE INFLATION, GAS-AT-THE-PUMP AND HURRICANES
First came emerging markets. Then commodities. And now economic derivatives.
First came futures. Then options. Now binaries.
The world as we know it is changing.
For decades, investors have been taught to diversify. Stock indexing became popular in the 80s. In the 90s, investors discovered international markets. In 2000s, they poured their money into gold, silver and energy. Now, new electronic venues are treading into what has been talked about for a long time: inflation, real estate, retail indicators, and insurance.
A typical U.S. household has 50% of its wealth in a primary residence, the rest split between financial assets and consumer durables. Its intangibles include the present value of the future earning power. Surely, indexing does not cover all relevant systematic risk.
But in order to get into the new risk areas, investors and traders alike had to travel up a learning curve. They moved from mutual funds to ETFs, and ETFs moved beyond passive stock strategies to include gold and silver, and to play long-short, and other more active strategies. Investors embraced options as a flexible strategic tool for levered investing and risk hedging. They also got familiar with spot currencies via unregulated FX shops. Now, at least some, come to play the economic derivatives game.
It used to be just offshore odds-making outfits that dominated that space. Then, U.S. regulators wised up and saw that speculating on GDP or inflation is not the same as gambling on basketball; it is rather similar to playing weather derivatives on the Chicago Mercantile Exchange, VIX contracts on the Chicago Board of Options Exchange or Fed Funds futures on the Chicago Board of Trade. It serves an economic purpose of price risk transference. The Chicago Merc teamed up with Goldman and Deutsche to launch CME/Economic Derivatives. And CFTC licensed HedgeStreet.com to open its electronic doors to U.S. traders of retail-oriented options and futures. While large institutions found little direct exposure to economic indicators, retail traders flocked to these new markets to take advantage of smaller contract denominations and to speculate on things that matter to them. On all venues, the most heavily traded contract structure is an all-or-nothing binary option. The binary is a perfect product for non-asset underlyings like hurricanes, real estate indices and inflation which may be observed only discretely and have no cash security form. And the binary seems to work great for speculating on traditional assets like gold, currencies and oil that are expensive for individuals to trade spot. The all-or-nothing payout engenders more leverage and more at-the-money action than standard calls and puts. Crossing a strike catapults you from zero to maximum payout right away. Delta can be much greater than one and time decay may actually work for you!
LEVERAGE
If you buy a share of MER for $75 on Monday, how high can it go by Friday? If it gets to $80, you make $5 or a 6.67% return on a $75 investment. Is this the best use for your $75? Perhaps you should buy 5 shares of MER. Well, that will only give you 5 x $5 return or $25 on a $375 investment or the same 6.67%.
Options traders will suggest another answer. Instead of buying a share of stock, buy 50 calls struck at $75, each for $1.50 in premium. When the stock reaches $80, your payout is 50 x $5 or $250. On a $75 investment, that is 233%.
Binary options go even further. When you buy 50 all-or-nothing calls struck at $75 at $1.50 each, the payout you will get is not variable, equal to the difference of the stock price at expiry and the strike, but a fixed dollar amount, say $10. So when MER reaches $80, your 50 binaries are worth 50 x $10 or $500. On a $75 investment, that is a net return 567%.
What is at play here is leverage. In this article, we will look at three ways of levering up – options, futures and binaries. We examine the behavior of the levered positions at and prior to expiry, taking into account potential time decay. We discover some unique aggressive and conservative trading strategies possible with binaries. We analyze their benefits and costs.
ALTERNATIVE STRATEGIES
Let us consider four gold investment alternatives. Suppose gold is trading at $645 on Monday and you think it will cross $650 by Friday. A simple Alternative 1 is to buy a 100 oz. bar of gold for $645/oz. Alternative 2 is to buy a call option struck at 650, paying a premium of $2.00/oz. for the call. Alternative 3 is to go long gold futures at 645 (assuming no spot-futures basis) and posting a 3% margin of $19.35. And Alternative 4 is to buy a $10 binary struck at 650, paying a premium of $2.00. Since they all require different dollar investments upfront, in order to compare apples to apples we will look at percentage returns rather than dollar returns. After all, if we have $50,000 to spend, we can use the full amount to buy several ounces of gold, many calls and binaries, or to post margin on several gold futures.
PAYOUT AT EXPIRY
In Alternative 1 (spot), if gold ends up at $660 on Friday, you pocket a $15 gain, or 2.326%, per oz. For each dollar rise in the gold price, you make one dollar (delta equal to one), which on a $645 investment is equal to 0.155% per $1 price change. Your dollar and percent return are constant per dollar price change. So if the price rises by $10 you make 10 x 0.155% or 1.55%. Your losses are also linear if gold declines, and your break-even point is 645.
In Alternative 2 (calls), if gold reaches 655 on Friday, your call will be worth $5.00. Since you paid only $2 for the call, you will have a 150% gain on your investment. If you are wrong and gold stays below 650, your call will be worthless and you will have a loss of 100% of your investment. You break even at 652.
In Alternative 3 (futures), if gold goes up, your mark-to-market gains will be added to your margin position. If gold reaches 650, you will have gained $5; at 655, you will have gained $10. The dollar gain is the same as for a spot gold investment, but the percentage gain is much greater due to a much lower cash commitment upfront.
In Alternative 4 (binaries), if gold reaches 655 on Friday, your binary will be worth $10 and you will have a 400% gain. If you are wrong and gold stays below 650, your binary will be worthless and you will have a loss of 100%. Your tradeoff is simply a 400% gain or a 100% loss. You have the same downside as with the call, but a much greater profit potential for a small move in the price of gold.
Let us graph the four alternatives side by side. Note that the vertical axis is percentage gain, not dollar gain. The horizontal axis is the gold price at expiry.
[click on thumbnail to view larger image]
Let us also summarize the four strategies in one composite table. The simple spot buy has the least leverage. With gold at 656, the gain is only 1.7%. The futures trade gains faster. With gold at 656, you can liquidate the position with a 56.8% gain, closing out your margin balance of $30.35. The call option is even more leveraged. At 656, the call is worth 6, for a gain of 4 or 200%. And the binary beats them all. At 656, the binary is worth 10, for a gain of 8 or 400%. The call will beat the binary if gold goes over 660. Beyond that point, the variable payout on the call will continue to increase, while the binary has reached its maximum.
[click on thumbnail to view larger image]
The cost of this leverage is risk. The spot buy of gold will lose little as gold goes down. The table numbers will be symmetric around the entry point of 645. When gold goes down $15 to 630, the loss will only be 2.3%. By then, the futures will have lost 15/19.35 or 77.5%, and the call and the binary will have lost 100% of the investment value. The binary game is not for the faint-hearted.
AGGRESSIVE STRATEGIES
Let us now turn to the properties of the binaries prior to expiry. A long position in a standard call is a tradeoff of a potential gain from the underlying’s price appreciation and time decay which slowly chips away at the option value. Since a binary is more akin to call spread rather than a naked call, its time decay function is more complex. Out-of-the-money, the option value decays, in-the-money the binary may actually gain value as the potential payout grow more certain. This property of the binary option can be a great return enhancer. Let us examine an aggressive strategy of buying slightly out-of-the-money options. It is risky because if the price does not move before expiry, the option value will decline to zero and the entire investment will be lost. But if the price does move, the leverage inherent in the option will produce a high percentage return.
Let us suppose that gold is trading at $699 and we think it will go up slightly, perhaps to $702. A standard call on gold struck at $700 trades at $2; a $10 binary on gold struck at $700 also trades at $2. Both options have one month left to expiry. A smart aggressive strategy will be to buy the binary instead of a call. The following graph illustrates why.
[click on thumbnail to view larger image]
If, as you predict, gold rises to $702 over the next few days, the gain on the call will be equal to its delta, roughly equal to 0.5 times the gain of $3, or the total of $1.5, making the call worth $3.50. The binary, having crossed the strike, will jump up close to its maximum value, perhaps to $8. You can then cash out, or, if you think there is little chance that the price will drop back down, you can take advantage of the reverse time decay. As the binary approaches expiry the price will actually increase to the full payout value of $10. Meanwhile, the call value will decline to its intrinsic value of $2.
The strategy makes little sense if the move in the price of gold is large. If gold jumps $21 to $720, the call’s delta will change vary quickly to 1.0, and its time decay will be close to zero. The calls value will be $20, while the binary value will stay at $10.
CONSERVATIVE STRATEGIES
Now suppose that you want to play it safe. You like options, because your cash commitment upfront is lower than that for a spot purchase of gold, but you don’t like the fact that leverage can multiply your losses.
Suppose gold is trading at $708. You want to own it, but you think it has limited upside and there is a great chance it could drop substantially. A standard call on gold struck at $700 trades at $9.50; a $10 binary on gold struck at $700 also trades at $9.50. Both options have one month left to expiry. A smart conservative strategy is to buy the in-the-money binary instead of a call. Again, let us look at a graph.
[click on thumbnail to view larger image]
If gold appreciates, the binary’s value will increase to $10, producing a gain of 5.3%. The standard call stands to gain more, but you want to protect the downside. If gold declines, but by less than $8, the call will decline almost dollar for dollar, then more slowly as its delta declines. Meanwhile the binary is not likely to decline at all. In fact, if gold stay above $700, the reverse time decay will force the price of the binary to converge to its payout of $10. If gold drops a lot, by more than $8, both options’ values will decline to close to zero. In this strategy, the binary tends to hold up its value longer as the underlying asset’s price does down.
EXAMPLE: BINARIES ON INFLATION
The appealing characteristic of binaries is that their prices can be interpreted as probabilities. Consider the prices quoted on HedgeStreet.com on September 14, 2006, on $10 binary options on the CPI index release the following day:
Source: http://www.hedgestreet.com/hedgelets/YesNo/dashboard.html
CONTRACT TIME UNDERLYING BID ASK LAST Δ%CPI
REMAINING LAST PRICE
CPI > 203.2 (14 Sep 06) 3h 45m 203.2 9.06 9.60 9.36 0.00%
CPI > 203.4 (14 Sep 06) 3h 45m 203.2 8.33 8.92 8.66 0.10%
CPI > 203.6 (14 Sep 06) 3h 45m 203.2 6.03 6.62 6.35 0.20%
CPI > 203.8 (14 Sep 06) 3h 45m 203.2 2.21 2.80 2.27 0.30%
Consensus estimate on the day of the quotes was +0.2%. Briefing.com predicted +0.4%. From the above quotes, we can see that the collective wisdom of the market participants placed the probability of CPI>0.2% at roughly 63.5% (pay $6.35 to receive $10) which seems to agree with the economists’ consensus and Briefing.com. But the market definitely did not agree with the high 0.4% prediction, giving it only a 22.7% probability. If one were to believe Briefing.com, then a smart aggressive play could be to buy the 203.8 (+0.3%) strikes which are slightly out-of-the-money given the consensus of 0.2%. A more conservative strategy would be to buy lower strikes, perhaps the in-the-money 203.4 (+0.1%) strikes. The upside is limited to 10.00-8.66=$1.34, but the chance of losing money is small. CPI would have to surprise below the consensus and the Briefing number.
From a longer-term investor perspective, note an interesting feature of an inflation hedge strategy. The more you are worried about inflation, the lower the strikes you will tend to buy. You will spend more each time, but also you are more likely to get a payout each time. The high risk aversion of the individual investor will be matched with a safe strategy. The less you worried about inflation, the more you will tend to hedge just the tails and choose higher strikes, which means often you will be wrong and will get no payout. But, since you are less risk averse to inflation risk, you will not lose much sleep over it.
