Technically Speaking

More on Binary Options:Bungees
By Mike Carr, CMT

Last month’s article on binary options prompted several inquiries on the subject. This month, we present more specific information. These contracts are available at HedgeStreet.com, similar products may be available on other exchanges.

HedgeStreet Bungees (limited risk futures) enable traders to potentially profit from rising or falling prices while limiting risk exposure to extreme price changes in volatile markets. These cash-settled contracts offer traders a variable payout structure while limiting the value of each contract at the upper and lower ends of each Bungee's range if the value of the underlying moves above the cap or below the floor. A trader's potential loss will not exceed the amount invested, and the potential gain is limited by the contract's cap (for buyers) or floor (for sellers).

Like a traditional futures contract, Bungee contracts are bought if the trader expects the price to rise, or sold if it's expected to fall. Traders gain or lose depending on how much the underlying price goes up or down. Bungees have total contract values of between $100 and $500, depending on the contract's range and tick value. Likewise, the gain or loss per tick varies depending on the contract, but ranges from $.01 to $1.00.

There are several unique Bungee contract features:

  • Small contract values ranging from $100 to $500

  • Short-term contract durations of 1 week

  • Well defined risk and reward payout structure

The cash requirement is the maximum that can be lost if the underlying ends at or below the floor (lower level) for buyers, or at or above the cap (upper level) for sellers. For a buyer, it is the contract price (calculated as the number of ticks above the floor, multiplied by the tick value). For a seller, it is the total contract value minus the contract price.

Final payout is based on the expiration value of the underlying asset relative to the Bungee's range. If the underlying asset expires at or below the floor, the payout for the buyer is $0 and the payout for the seller is the contract's maximum value. If the underlying asset expires at or above the cap, the payout for the buyer is the contract's maximum value and the payout for the seller is $0. If the underlying asset expires between the floor and the cap, the buyer receives $X per tick above the floor, up to the expiration value and the seller receives $X per tick below the cap, down to the expiration value.

As an example, we can consider a contract on the Euro/US Dollar exchange rate. This would be quoted as 3PM EUR/USD 1.3900 to 1.4100 (W) Bungee. This means that it expires at 3 PM at the end of the week. The total contract value is $200.

Assume you are bullish on the spot EUR/USD, and it is currently trading at 1.3982.You decide to be a buyer. You enter the following order, which is slightly below the market:

Buy 1 3PM EUR/USD 1.3900 to 1.4100 (W) Bungee at 1.3962
As a buyer, the price you pay to purchase the contract is the number of ticks above the Bungee's floor, multiplied by the tick value for the asset. Since each underlying EUR/USD tick movement of 0.0001 is equivalent to $1, your cost to initiate this trade (the "contract price") will be $62 (plus an exchange fee), calculated as follows:

1.3962 (initial price) - 1.3900 (floor) = 0.0062 (62 ticks) * $1 tick value = $62

Assuming your order is executed, you are long at 1.3962. The person on the other side of the trade, the seller at 1.3962, had a cost of $138 (plus an exchange fee), calculated as follows:

$200 (contract value) - $62 (buyer's contract price) = $138

Alternatively, the seller's cost can also be calculated as the number of ticks below the Bungee's cap, multiplied by the tick value for the asset:

1.4100 (cap) - 1.3962 (initial price) = 0.0138 (138 ticks) * $1 tick value = $138

There are several possible scenarios at the time of contract expiration:

1. The market moves against the buyer's long position and the EUR/USD expires below 1.3900. The buyer can only lose the initial cost, which is the maximum risk, of $62 (plus exchange fees).

2. The buyer holds the Bungee to expiration as the market is rising, and the contract has an expiration value of 1.4025 for the 3PM EUR/USD. The buyer's payout is $125 (less exchange fees), calculated as follows:

1.4025 (expiration value) - 1.3900 (floor) = 0.0125 (125 ticks) * $1 tick value = $125

This $125 payout reflects a return of the buyer's original cost of $62 plus a profit of $63.

3. The buyer holds the Bungee to expiration as the market rises strongly, and the contract has an expiration value of 1.4140 for the 3PM EUR/USD. Since the expiration value exceeds the cap, the buyer's payout is the contract's maximum value, or $200 (less exchange fees), calculated as follows:

1.4100 (cap) - 1.3900 (floor) = 0.0200 (200 ticks) * $1 tick value = $200

This $200 payout reflects a return of the buyer's original cost of $62 plus a profit of $138.

When the expiration value is above the cap, the buyer's payout is limited to the contract's maximum value (in this case, $200).

4. The Bungee is trading at 1.4001 with 2 days until the contract expires. The buyer has a change of market view and decides to get out of the position prior to expiration. If the long position is liquidated at 1.4001, the net profit would be $39 (less exchange fees), calculated as follows:

1.4001 (liquidation price) - 1.3962 (initial price) = 0.0039 (39 ticks) * $1 tick value = $39

These contracts may not offer hedge fund-style paydays, but they do offer the ability to offset risk in smaller accounts.

This article is adapted from material available online at http://www.hedgestreet.com/howto/bungees-trading/