Overview

As betting markets become more and more sophisticated (epitomised by
the advent of specialist sports hedge funds) the crossover between sports
betting and financial trading will intensify. Already futures trading by way
of spreadbetting has become established in the sports betting market,
while in turn fixed odds bets, by way of binary options, are being
increasingly used for speculating in the financial and commodity markets.
Binary options (aka financial fixed odds bets, aka binary bets) have a
number of characteristics which will enable them to become the most
heavily used and popular derivatives instrument. They provide:
1. easy access for the trader via the internet;
2. a limited risk environment for all participants;
3. at expiry greater gearing for the speculator than, for instance, futures,
CFDs, spreadbets or conventional options;
4. a far greater degree of flexibility enabling the sophisticated trader to
customise his bet to take full advantage of accurate forecasts;
5. a product range that ranges from financial and commodity instruments
to sports, political, media and weather; and finally
6. they are tax-free in many jurisdictions.
Binary options are used by people in many countries, albeit under a
different name – that of a fixed odds bet. Nowadays many nations have
their Kentucky Derby, Breeder’s Cup, Grand National and Melbourne
Cup, which attract wagers from a broad range of people; and recently
betting on ‘reality TV’ events has become popular. All these betting
participants are (unwittingly) buying binary options, and the flexible
nature of this instrument will enable it to pervade the lives of many of
whom are already avid sports punters but have always shied away from
participating in the world of sophisticated financial instruments.
Henceforth the term fixed odds bet will be interchangeable with the term
binary option throughout this book.

Distribution
Hitherto, if one ignores fixed odds sports betting, binary options have
been very much the preserve of the financial OTC (over-the-counter)
market. Financial and commodity derivatives markets generally restrict
themselves to offering futures and conventional options while the stock
markets offer shares only. One must suspect the omission of binaries from
derivatives markets has been an oversight, while from stock exchanges
one suspects an attitude bordering on snobbery owing to the speculative
nature of the instrument.Whatever the reason, these exchanges are likely
to watch in awe as the trading volumes on binary/betting exchanges soar.
What are the grounds for such an assertion?
The following points explain why this instrument will see the same
exponential growth that futures/options exchanges did throughout the
latter half of the 1980s and most of the 1990s. The basic tenet springs
from the fact that since binary option positions create a quantifiable
maximum downside risk, this results in:
1 Risk Management
Conventional options are the most heavily exchange-traded option, yet
volumes rarely exceed that of the underlying future with one or two
exceptions (e.g. the Kospi index). This can be partly explained by the endusers’
reticence in using a complicated instrument, but the major constraint
is the reluctance of brokers to offer accounts to many customers who may
not be capable of sustaining the potential losses that can be incurred from
losing positions. These losing scenarios will always be predicated on the
naked writing of options that occasionally explode, leaving the short with
a potentially limitless, unrecoverable debit on his account.
In contrast to the above high-risk situation, the binary option enables all
potential losses to be calculated on the inception of the trade, since the
price of a binary option is constrained by the limits of 0 and 1. As we will
see later, writing (selling) a binary call has the identical profit & loss (P&L)
profile of buying the same strike put of the same series. On selling an
out-of-the-money call at 0.2 (equivalent to a 4/1 bet) the seller’s maximum
loss will be at 1.0, where he will lose four times the amount he sold.
Clearly the broker is likely to have less unease in opening accounts for
clients with this scenario; and if the broker insists on 100% upfront
payment of the maximum potential loss, then the broker’s potential
liability is now totally covered.