At first glance, the business of trading seems very simple: an asset can either go up, go down, or move sideways. Easy right? Far from it! As traders, we encounter complexity when we try to express our opinion on where prices will head in the future. First of all you need to time your trade correctly. Second, you need to pick the best financial instrument to trade given the move you expect. We define “best” to mean the choice that gives us the most return given the amount of risk we take.
For example, suppose you expect the US equity market to rise in the near term. There are a number of way’s you can profit from a rise in the market:
- You could buy a basket of 500 stocks that tracks the market
- You could buy an e-mini S&P 500 future contract
- You could take a long position via vanilla options
- You could take a long position via binary options
The first option is by far the worst from a risk/return perspective, even if you are later proven correct and the market rises in price. Not only do you have to manage 500 symbols, no small feat for human traders, the capital you would have to put up would be the highest of all four choices. If the market rises 4% in a week, that’s what you will make, minus signifcant commissions, but your risk will be far greater in terms of the absolute dollar amount you have on the line.
The second option requires far less management (you only have to buy one contract) and less capital to maintain the position (the collateral required is set by the exchange and changes from time to time, but its usually around $5,000). If the market goes up by 4% you will likely make far more than that in terms of return on margin. But this metric is misleading: if you’re wrong and the market drops quickly, you could end up losing more than the money you put up in margin.
Vanilla options offer another way to go long, and they address some of the shortcomings of the previous two methods: 1) your risk is capped and known in advance and 2) if you’re right and the market rises your ROI will be very attractive. However, there are no free lunches in the market and these features come at the cost of increased complexity in how the product trades. Vanilla options have a premium that is based on unobservable mathematical variables (the greeks) which are not necessarily the easiest thing pick up for your average person without a math Phd. Moreover, the premium paid for an option doesn’t have an immediate intuitive interpretation, you have to use math and some assumptions about the market to convert a vanilla option premium into a probability that an event will occur.
Binary options may offer a more intuitive alternative. While binary option prices are based on similar concepts to their vanilla counterparts — expected future volatility plays a huge role in pricing both types of options — binary options are priced between 0 and 100, and their payout is simply defined. If the settlement price for a binary option closes above its strike by expiration, the payout is 100, below the strike the payout is nothing. Thus the price you see prevailing is the expected probability of the settlement price closing above the binary options strike price. This is much more intuitive for most traders to understand as we tend to think in probabilities to begin with.
It seems reasonable to conclude that long options, in general, address many of the major short-comings with cash and futures trading. Options provide a capped risk profile with significant ROI potential. However, Binary options are appealing because they are the most intuitive to understand as their price is a sort of proxy for the expected probability of an event occurring by expiration. The main caveat is these options cap reward as well as risk, making them somewhat similar to a vanilla call spread (where a trader buys 1 call at a lower strike and sells another at a higher strike, capping risk and reward). On the other hand, going long vanilla call options can have uncapped potential return but only at the expense of being a harder market to understand and price intuitively.