Derivatives, Binaries, Futures, or… Prediction Markets?

Chris F. Masse June 2nd, 2008

Jason Ruspini, mister the VP, how would you explain to the Midas Oracle readers the difference between “binaries” and “futures” (a la HedgeStreet, circa Russell Andersson)? Does that vocabulary (still) make sense? Would it be better for them to switch to the “prediction markets” vocabulary, now that this is more prevalent in modern-days media articles, and since prediction exchanges are in fact a b-to-c business??

HedgeStreet, circa Russell Andersson:

Binary Options
Binaries Description

Binaries have the following characteristics:

* A Binary is a $100 contract between a buyer and a seller (both HedgeStreet members) - the buyer taking the position that a certain strike price will be reached or a certain event will happen on the expiration date, and the seller taking the position that it will not.
* Buyers and sellers trade contracts at prices based on their sense of the perceived likelihood that a price will or will not rise, or an event will or will not happen. Thus, the value of each Binary is equivalent to the probability of the corresponding situation, as the potential gain is always a fixed amount of $100 per contract.
* Since the value of each Binary is equal to the perceived probability of the event occurring, all contracts can be immediately compared. For example, if an event appears to have an 80% chance of happening, the buyer pays $80 per contract, and the seller pays the balance of the $100 contract, or $20.
* If the price of the underlying exceeds the strike price or the event does happen on the expiration date, the buyer receives $100, and the seller gets $0, thereby losing their initial investment.
* If the price of the underlying does not exceed the strike price or the event does not happen on the expiration date, the seller receives $100, and the buyer gets $0, thereby losing their initial investment.

Cash requirement:
The cash requirement is the maximum that can be lost if the predicted outcome does not occur. For the buyer, it is the contract price. For the seller, it is $100 minus the contract price.

Final payout:
At expiration, the payout is always $100 per Binary. The buyer receives $100 if the price of the underlying exceeds the strike price or the event does happen and $0 otherwise. The seller receives $100 if the price of the underlying is equal to or below the strike price or event does not happen and $0 otherwise.

Additionally, traders can close out their positions prior to expiration by selling (in the case of an initial buyer) or buying (in case of an initial seller) their Binaries at any time before the last trading date. In such cases, the profit and loss is the difference between the price received and the price paid.

HedgeStreet, circa Russell Andersson:

Futures Contract Description
-
Futures Contracts have the following characteristics:

1. A Futures Contract is a $0 - $100 Futures contract between traders where one takes the position a market will rise (the Buyer), and the other takes the position the market will fall (the Seller).
2. Traders determine Contract prices based on their sense of the likelihood of the outcome.
3. If the market rises, Buyers profit and Sellers lose, according to the amount of the rise.
4. If the market falls, Sellers profit and Buyers lose, according to the amount of the fall.
5. The cap and floor of the Contract’s range limit the potential loss to the amount invested, and limit the potential gain to $0-$100 (the contract size).

Cash requirement:
The cash requirement is the maximum that can be lost if the underlying ends at or below the Floor (for Buyers) or at or above the Cap (for Sellers). For a buyer, it is the contract price. For a seller, it is the contract size (which is up to $100) minus the contract price.

Final payout:
At expiration, the payout is based on the ending level of the underlying, relative to the Contract’s range.

If the underlying ends at or below the floor, the payout is $0 for the buyer and the stated contract size (of up to $100) for the seller. If the underlying ends at or above the cap, the payout is the stated contract size (of up to $100) for the buyer and $0 for the seller.

If the underlying ends between the floor and the cap, the stated contract size is split between the buyer and seller, where the buyer receives $Y for every X tick the underlying finished above the Floor and the seller receives $Y for every X tick the underlying finished below the Cap, such that payout for the buyer increases when the underlying ends closer to the cap, and payout for the seller increases when the underlying ends closer to the floor.

Example: For Crude Oil $70.00 to $80.00, with a $100 contract size - if Crude Oil ended at $77, the buyer would receive $10 for every $1 Crude Oil finished above $70, or $70, while the seller would receive $10 for every $1 Crude Oil finished below $80, or $30.

Additionally, traders can close out their positions prior to expiration by selling their Futures Contracts at any time before the last trading date. In such cases, the profit and loss is the difference between the price received and the price paid.

I took those excerpts on the old HedgeSteet website. It may not reflect their current website. Visit them to get updated, if you need.

One Response to “Derivatives, Binaries, Futures, or… Prediction Markets?”

# Jason Ruspini on 02 Jun 2008 at 6:58 pm

There’s not much difference between the two with event markets. The important thing is that both futures and options are within the CFTC’s jurisdiction.