Buy Low -- Sell High with Binaries

If you are trading futures, options, foreign currency or even equities today, you're always on the lookout for a new way to possibly enhance your returns.

My name is Dr. Robert Dubil (aka Dr. Bob). I am the Chief Strategist for HedgeStreet and also Associate Professor of Finance at the University of Utah. My background includes having been Director of Risk Analytics Technology and Senior Strategy Consultant for Merrill Lynch. And during my career in the financial markets, I've held numerous positions related to options and derivatives trading for firms such as Chase Manhattan Bank, Nomura Securities and Union Bank of Switzerland.

In this article I'd like to teach you about new way to trade called Binaries.

Binaries are simple contracts that have only two possible outcomes. If you are correct about a price being reached or an event occurring you receive the full value of the contract. If not, you lose the amount you paid for that contract. You can also take the position that a price or event will not occur with the same payout structure. All U.S. exchanges where binaries are traded are subject to regulatory oversight by the Commodity Futures Trading Commission (CFTC), an independent agency with the mandate to regulate the sale of commodity and financial futures in the U.S.

The allure of a Binary contract is the ability to possibly make significant returns on small moves of the underlying – while always knowing exactly how much capital you have at risk. Binary contracts can be used either as a standalone position or in conjunction with conventional derivative contracts. Since Binaries are new to the U.S. market, there are likely many combination strategies yet to be discovered to be used along with futures, options and foreign currency. The following article provides an introduction to Binary contracts and their benefits.

Buy Low -- Sell High With Binaries

Everyone wants to buy low and sell high. Preferably, very high. If you buy a share of IBM for $75 on Monday, how high can it go by Friday? At $80, you make $5 or a 6.67% return. Is this the best you can do? Not at all.

What you need is leverage. You want each dollar invested to have a potential to produce a higher gain. In the IBM stock case, each $1 of the stock rise is equivalent to a 1/75 or 1.33% return since you had to invest $75 upfront. Buying more of the same, i.e. another share of IBM, is not going to produce a higher return per dollar invested. You will simply get more dollars back.

Let us look at three ways of leveraging up -- options, futures and binaries -- and compare them to a simple spot purchase to highlight their pros and cons.

Suppose gold is trading at $645 on Monday and you think it will cross $650 by Friday. Here are your alternative strategies.

Base case. Buy a 100 oz. bar of gold for $645/oz. 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 $1/$645 or 0.155%. Textbooks usually portray this situation on a payoff diagram showing dollar gain per dollar change in the price of the asset. But let us also look at the percent gain per dollar change in the price of the asset. The picture will look like this.

Alternative 1: Call options. Instead of buying gold, you buy a call option struck at 650. You pay a premium of $2.00 for the call. If gold reaches 655 on Friday, your call will be worth $5.00 and 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.

Alternative 2: Futures. You go long gold futures at 645 (assuming no spot-futures basis). You don't have to pay anything, but you have to post a 3% margin or $19.35. If gold goes up, your 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 picture looks the same as for a spot gold investment, but the percentage gain graph is much steeper due to a much lower cash commitment.

Your potential losses are steeper too. If gold goes down to 640, $5 will be taken out of your margin account for a loss of 25.84%.

Alternative 3: Binaries. You buy a $10 binary struck at 650. You pay a premium of $2.00 for the option. If gold reaches 655 on Friday, your binary will be worth $10 and you will have a 400% gain on your investment. If you are wrong and gold stays below 650, your binary will be worthless and you will have a loss of 100% of your investment. In fact, your tradeoff is simply a 400% gain or a 100% loss. You have the same downside as with the call, but a much steeper profit profile (vertical).



Let us 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%. But the binary beats them all in our example. At 656, the binary is worth 10, for a gain of 8 or 400%. The call will only beat the binary if gold goes over 660.

The cost of 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.

Nothing in life is free, but if you think something is going up in price, buy low and sell very high by using binaries.

Robert Dubil, Ph.D. is Chief Strategist of HedgeStreet, has had successful careers both in the financial industry and in academia. In the former, Dr. Dubil's positions have included director of risk analytics technology and senior strategy consultant for Merrill Lynch; director of U.S. fixed income options trading and quantitative analysis for Union Bank of Switzerland; head of U.S. dollar exotic options for Chase Manhattan Bank; and VP, derivatives trader for Merrill Lynch and for Nomura Securities. The author of An Arbitrage Guide to Financial Markets as well as numerous scholarly papers, Dr. Dubil is currently Associate Professor of Finance at the University of Utah. He holds a Certificate in EEC Law & Economics from Tilburg University, Netherlands; an MA (ABD) in finance from the University of Pennsylvania, Wharton School; and an MBA in finance/ statistics and a PhD in finance from the University of Connecticut.