Let's Talk About Binary Derivatives

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What Are Binary Derivatives?
There is a great deal of confusion over binary derivatives these days. What are these unique products and how can you incorporate them into your trading strategy?

In short, binomial derivatives are designed around a simple yes/no proposition. To use a sports analogy, think of them as over/under contracts. These contracts have a designated payout value and specific conditions that must be met in order to receive that payout. If those payout conditions are met, then the owner of the contract receives its full value. If not, then the contract expires worthless. It's a very simple and direct way to trade.

Let's take a look at an example:

Binary Example
You believe that inflation in the U.S. will be high this year, so you purchase a binary derivative on the Consumer Price Index (CPI) for $36. The terms of this contract state that it will pay out its full value of $100 if the 2007 CPI is above 2%. There are only two potential outcomes for this contract, which is why it is known as a binary derivative.

1. The final CPI number for 2007 is above 2%. In this scenario, the payout conditions of the contract are fulfilled and you receive the full $100 value of the contract. This results in a profit of $64 before taxes and commissions.
   
2. The CPI number for 2007 is below 2%. In this scenario, the payout conditions of the contract have not been met and the contract expires worthless. This results in the loss of your initial $36 investment.

Options Or Futures?
Are binary derivatives options or futures? The actual definition of these products is open to interpretation. It all depends on how the contracts are structured. Thebinary nature of these products means that they will perform in manner similar to options. However, they may also have marginrequirements that are very similar to futures.

We saw this options/futures debate play out over the past year when the CBOE and CME clashed over their new binary credit derivatives. The problems began when the CME chose to designate their binary credit derivatives as futures, thereby allowing them to apply for CFTC approval. The CBOE had similar binary credit derivatives, but their contracts were designated as options. This forced them to apply to the SEC for final approval of the products. As any observer of the derivatives world knows, this put them at a severe competitive disadvantage to the CME.

The CBOE argued that the CFTC has no jurisdiction over binary credit derivatives because these products are, in fact, options. However, the CFTC disagreed and approved the CME's binary credit futures earlier this year. This back and forth debate highlights just how confusing and contentious it can be to classify binary derivatives.

Terrorism & Event Derivatives
Everyone wants to make a killing in the market, but only the sickestamong us mean that literally. The furor over the Defense Departmentísproposed ìTerrorism Futures Exchangeî back in 2003 was proof of that.Although the Defense Advanced Research Projects Agency's (DARPA's)exchange was a very interesting idea, it was scrapped because of thenegative stigma associated with speculating on human life.

While theìTerrorism Futures Exchangeî never came to fruition, itís very publicdemise didnít put an end to speculating on questionable events. Anumber of people in the derivatives community picked up DARPA's ball and ran with it. In fact, several derivativesexchanges have staked their futures, pun intended, on these extremelycontroversial products. Pandoraís Box is about to be opened once again,and this time there may be no closing it.

Continued in "Let's Talk About Binary Derivatives Part Two: Event Derivatives"...

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