Chris F. Masse July 3rd, 2008
Via Fabian John (Financial Services Consultant)
Speculative Trading with Binary Options - by Kurt Eckhardt
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Sphere: Related ContentChris F. Masse June 18th, 2008
CFTC’s Concept Release on the Appropriate Regulatory Treatment of Event Contracts
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II. Commodity Options and Futures and the Attributes of Event Contracts
The Commission, with some exceptions, has exclusive jurisdiction over two relevant types of derivative instruments —commodity options and commodity futures contracts.
Section 4c(b) of the Act gives the Commission plenary jurisdiction over commodity options, and provides that “[n]o person shall * * * enter into * * * any transaction involving any commodity regulated under this Act which is of the character of, or is commonly known to the trade as, an option * * * contrary to any rule, regulation or order of the Commission[.]”
Section 2(a)(1)(A) of the Act provides that the Commission shall have exclusive jurisdiction with respect to accounts, agreements, and transactions (including options) involving contracts of sale of a commodity for future delivery.
Event contracts, depending on their underlying interests, can be designed to exhibit the attributes of either options or futures contracts.
A significant number of event contracts are structured as all-or-nothing binary transactions commonly described as binary options. \8\ Binary event contracts typically pay out a fixed amount when an outcome either occurs or does not occur. The trading of such contracts can facilitate the discovery of information by assigning probabilities, through market-derived prices, to discrete eventualities. For example, a binary contract based on whether a particular person will run for the presidency in 2012, can pay a fixed $100 to its buyer if and only if that individual runs for the presidency in 2012. If the contract’s traders believe that the likelihood of the individual’s candidacy in 2012 is around 17 percent, the price of the contract will be around $17, and will approximate the market’s consensus expectation of the individual’s candidacy.
\8\ See, e.g., Intrade Prediction Markets, Current Events Contracts
In addition to binary event transactions, the term event contract has also been used to identify transactions, based on interests other than market prices, which resemble futures contracts. For instance, these types of event contracts can price consensus estimates of moving values, such as the number of hours the average U.S. resident spends in traffic or the share of votes that a particular candidate for political office may receive. Unlike binary transactions, and similar to any commodity futures contract, this type of contract creates continuous and ongoing obligations that are linked to moving measures or levels, as opposed to being dependent on the outcome of a single discrete occurrence.
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III. The Commission’s Regulatory Purview
[...]
For the purpose of discussion and analysis, the types of event contracts that Commission staff has reviewed can be categorized, albeit imperfectly, as contracts that are based on narrow commercial measures and events, contracts based on certain environmental measures and events, and contracts based upon general measures and events.
Narrow commercial measures quantify and reflect the rate, value, or level of particularized commercial activity, such as a specific farmer’s crop yield.
Narrow commercial events, on the other hand, are events that might, in and of themselves, have commercial implications, such as changes in corporate officers or corporate asset purchases.
Environmental measures can be characterized as quantifications of weather phenomena, such as the volatility of precipitation or temperature levels, that do not predictably correlate to commodity market prices or other measures of broad economic or commercial activity.
By comparison, environmental events can include the formation of a specific type of storm, within an identifiable geographic region, the likelihood of which will not predictably correlate to commodity market prices or measures of broad economic or commercial activity.
General measures can be described as measures that are not commercial or environmental measures. As such, general measures do not quantify the rate, value, or level of any commercial or environmental activity and can, for example, include the number of hours that U.S. residents spend in traffic annually or the vote-share of a particular presidential candidate.
Similarly, general events, such as whether a Constitutional amendment will be adopted or whether two celebrities will decide to marry, can be described as events that do not reflect the occurrence of any commercial or environmental event. The category of general measures and events can be further divided into a multitude of subcategories, such as political or entertainment measures or events.
Since 1992, Commission-regulated exchanges have listed for trading a variety of commodity futures and options contracts with payout terms based on interests other than price-based interests. These contracts involve interests as diverse as regional insured property losses, the count of bankruptcies, temperature volatilities, corporate mergers, and corporate credit events. \12\
While not strictly price-based, the interests underlying these contracts have been viewed by Commission staff as having generally-accepted and predictable financial, commercial or economic consequences.
In other words, unlike the interests that event contracts cover, these underlying interests have been viewed as measures and occurrences that reasonably could be expected to correlate to market prices or other broad-based commercial or economic measures or activities.
\12\ For example, the Chicago Board of Trade’s catastrophe single event insurance option contracts (which are no longer listed) paid out a fixed amount if and only if insured property damage exceeded $10 billion for a specific region during a specified interval of time.
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Sphere: Related ContentChris F. Masse June 10th, 2008
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Do the economists like Robin Hanson agree with Tom W. Bell’s classification?
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Sphere: Related ContentChris 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??
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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.
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HedgeStreet, circa Russell Andersson:
Futures Contract Description
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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.
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I took those excerpts on the old HedgeSteet website. It may not reflect their current website. Visit them to get updated, if you need.
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See also TradeFair’s binaries.
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My preferred vocabulary for InTrade and BetFair’s services:
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Sphere: Related ContentChris F. Masse June 1st, 2008
The Wikipedia entry on prediction markets does not seem to be well maintained.
Here are the warnings that welcome visitors. The first of the 2 warnings has been up since November 2007 —that’s 7 months ago!!!!!!
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And the definition opens on the big myth, create by IEM, and perpetuated by some scholars:
Prediction markets are speculative markets created for the purpose of making predictions.
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It’s a big myth.
The TradeSports and BetFair prediction markets were primarily created to satisfy the traders —their predictions come as an interesting offspring.
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Sphere: Related ContentChris F. Masse May 18th, 2008
Via Emile Servan-Schreiber of NewsFutures, John Auters in the Financial Times.
[...] This leads to [Justin Wolfers]‘ claim that [prediction markets] are the best way to aggregate information. This is true of any given amount of information. Take three economists and make them trade out a market over their predictions for next month’s inflation number, he suggests, and they will arrive at a more accurate prediction than a poll of the same three economists. In a market, those with stronger conviction (or inside information) can express that conviction; those less confident will not be willing to stake money. [...]
Prediction markets remain subject to the same weaknesses as other markets. The principle of “garbage in, garbage out” [*] applies. If there is only poor information to aggregate, they will be as wrong as everyone else. [...]
It would make sense to incorporate these odds when making investments. [...]
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Excellent.
(I don’t get his micro slam against the wisdom of crowds. Anyway.)
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[*] As explained in the prediction market explainer published on the frontpage of Midas Oracle.
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Sphere: Related ContentChris F. Masse May 16th, 2008
ABC 20/20 featuring InTrade - (May 9, 2008)
Foretelling The Future: Online Prediction Markets — (4 pages in all)
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Sphere: Related ContentChris F. Masse May 13th, 2008
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I would lay out this dichotomy:
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Some people would enjoy the usage of a “useful counterweight” —but not that many.
The “useful counterweight” thing is not a hot-selling proposition.
You don’t draw crowds with that.
You draw crowds with an over-selling proposition.
You draw crowds by manufacturing hype.
As a result of the collective intelligence of more than 77,000 bettors on Intrade, the prices on the site may be a good way to predict the outcome of current events — more accurate than some polls and pundits. In 2004, the market odds on Intrade predicted the presidential vote of every state but Alaska. In 2006, the odds correctly indicated the outcome of every Senate race.
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Our Explainer On Prediction Markets
Prediction markets produce dynamic, objective probabilistic predictions on the outcomes of future events by aggregating disparate pieces of information that traders bring when they agree on prices. Prediction markets are meta forecasting tools that feed on the advanced indicators (i.e., the primary sources of information). Garbage in, garbage out… Intelligence in, intelligence out…
A prediction market is a market for a contract that yields payments based on the outcome of a partially uncertain future event, such as an election. A contract pays $100 only if candidate X wins the election, and $0 otherwise. When the market price of an X contract is $60, the prediction market believes that candidate X has a 60% chance of winning the election. The price of this event derivative can be interpreted as the objective probability of the future outcome (i.e., its most statistically accurate forecast). A 60% probability means that, in a series of events each with a 60% probability, then 6 times out of 10, the favored outcome will occur; and 4 times out of 10, the unfavored outcome will occur.
Each prediction exchange organizes its own set of real-money and/or play-money markets, using either a CDA or a MSR mechanism.
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Sphere: Related ContentDeep Throat May 12th, 2008
If suspicious betting is detected then the winnings of the specific accounts in question are frozen until such time as BetFair have had the chance to investigate and determine one way or the other. That has no effect on BetFair’s ability to settle the market for every other customer. If one trader has placed a bet on a match in good faith, that trader’s bet wins, and there’s a subsequent investigation, there is no reason whatsoever to disadvantage that trader by withholding settlement, particularly as a full investigation could take weeks.
That applied for the Hernandez v Brezezicki match.
Sphere: Related ContentChris F. Masse April 29th, 2008
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Both InTrade and NewsFutures are in the process of overhauling their website. We’ll see within the next weeks what they have to offer.
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