Binaries, or Fixed Return Options (FROs) explained

Written on May 10, 2008 by OptionsRopeaDope

Not as well explained as some.. here is the TradeKing announcement of their offering. HedgeStreet is also an innovator in this area. Go to there or Gogle for lots of detail. I have, and I’ll just give a summary of what I think I understand these derivatives to be.

A Binary or FRO is much like an option, except it pays a maximum of $100. So if you buy one way out of the money, and the price exceeds that strike, You are paid $100 no matter how high it goes. There are some intereting “bets” you can make with thse that are very specific at HedgeStreet, such as things about weather, or how much the Fed will cut the prime lending rate, or what the housing numbers will be, and that might be useful, but my prmary interest is on price movement.

We know the return ($100), so the key thing to understand is how are they priced? The are prices by the market, as the probability the underlying will be at or past the strike. So what does this sound like?

Sounds like a debit spread to me. Debit spreads payout the max at the distance between strikes - which for some underlyings (SPY, IWM, QQQQ, others) are a strike, or $100 apart. Obviously there’s a little difference… normal debit spreads aren’t just all or nothing at expiration (although most of the time they are!).

So, I was thinking there may be some arbitrage opportunities for these. For example…

• If there is a discrepency in the price between the binary at a certain price, and the debit spread priced with normal options, where the short is the same as the binary(or FRO) strike - Bingo, opportunity. Buy one, sell the other, as the prices should come back in line by expiration, if not as soon as someone else sees the same thing and iles on.
• Not sure how to do this, but I imagine there might be some conversion/reversal style strategies with in the money binary strikes, and puts or calls with tradtional options and the underlying. Might think more about this for fun later on.

So there’s some thoughts. Honestly, I can’t think of a very practical use for these things, as they could all get “arbed” away. Oh wait! It’s commissions (or half the commissions)… that’s the difference  

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