Binary Options: The Market's Unsung Hero
The Japanese Financial Services Authority (JSFA) will soon be issuing new regulatory directives for binary options providers having characterized binary options as gambling.
As the author of 'Binary Options: Fixed Odds Financial Bets,' I would be rather pressed should I attempt to argue that binary options is never gambling. Yet to some market participants, trading and taking positions in binary options isn't gambling but is a means of providing insurance cover to countless people and corporations around the world.
This article endeavors to highlight the positive impact on our everyday lives that binary options have, while pointing out that the current ultra-short-term binary options on financial products that the JFSA is looking to address ought to be treated as a harmless leisure activity when compared to the final atrocities of the banks in 2008.
Nothing New Here
Binary options are not a new instrument as hordes of marketers would have us believe. The FX interbank market has been trading them for years. This most sophisticated of markets uses a wide range of binary instruments ranging from vanilla binary calls and puts to convoluted constructs involving knock-out, knock-in and two-asset binary options. These tailor-made binary options strategies are used to transfer exchange rate risk away from international trading companies and thereby oils international trade by creating competition in the marketplace that is beneficial to the consumer.
It is not just the FX market that uses these instruments. The base metal markets also utilize binary options in their various formats thereby enabling manufacturers to more proficiently plan ahead as the cost of their raw materials is fixed in advance. The oil industry is another user of binary options, thereby helping to eliminate the wider price swings of energy costs and manufacturers raw materials.
The insurance sector is also another major user of binary options, where they are referred to as industry loss warranties (ILWs). The Insurance-Linked Securities market uses ILWs to great effect in the catastrophe risk transfer market where capital market operators are assuming the insurance risk based on events such as hurricanes, typhoons, earthquakes, tsunamis, flooding and even volcanic activity. These instruments could be on property damage in Florida for a given 'named' hurricane, or for property damage for a period of time, e.g. a calendar year. The insurance companies all report in their property exposure to a chosen body, commonly the Property Claims Service (PCS) and the PCS aggregates these claims and comes up with a final assessment for the industry. An ILW has a trigger (strike price) that should the PCS final number pay out then the ILW buyer receives the difference between the 'rate-on-line' (premium paid) and sum insured. The ILW buyers are generally the insurance companies who sell cover directly to the household or business, while the ILW sellers are the reinsurance companies.
Yet again the transfer of risk from the insurance companies to the reinsurance companies by using binary options enables the insurance companies to provide cover at lower rates than would otherwise be the case.
Recently, an application was made to the CFTC to offer bets on the box office receipts of the film industry. It was turned down and by so doing, the CFTC outlawed the use of hedging instruments, binary options included, that would have enabled the film backers to hedge away some of the risk on the film being a dud. This is a strange state of affairs since pension funds are almost encouraged to write out-of-the-money calls against their portfolios of stocks and shares in order to enhance the return of the portfolio. By prohibiting this sort of hedge in the film industry, the film makers are automatically paying more for their financing. This is a pity; maybe the CFTC were concerned that the Brad Pitts' of the world might write binary options, i.e. go 'short', on the film they're currently involved in and subsequently put in an acting performance more akin to Arnie!
A binary option is no more than the financial and commodities market's term for a fixed odds bet, just as the insurance sector calls it an ILW. But even recognized as a fixed odds financial bet, the damage that these instruments can do is strictly limited since the price of the bet is constrained to be within the range 0-100. If one were to compare the risk to the public posed by these instruments it is negligible compared to the possible damage caused by regulated futures and short conventional options positions, or indeed banks punting the US home loan market. The buyer of binary options can be comfortable in the knowledge that they can lose no more than the premium paid or 100 less the premium if a binary options seller. They offer greater gearing than any other financial or commodity instrument and provide an adrenalin rush which is more in keeping with a game of roulette. It is a game of skill whereby through astute reading of charts etc. can provide the binary options trader to beat the house.
Binary options are at the root of all financial instruments, in a similar manner that binary code is at the root of all software languages. Far from living up to the market's bad boy image, binary options are extremely dextrous instruments that facilitate trade that in itself lowers the costs of services and products across a swathe of industries.
Hamish Raw is an options market-maker, owner of Binary Options and entrepreneur.