December 12, 2014
Why traders, brokers and FCMs should embrace these new products
- A new product that is catching on
- An expanding audience for these tools
- Futures commission merchants are behind the curve
- What is holding up the process?
Binary options are limited risk contracts based on a simple yes/no market proposition. The term of these instruments range from 20 minutes to one week–they are short-term trading vehicles. These tools represent a variety of markets. Binary options in stock indices are available on some of the major indices that trade on futures exchanges in the US, UK, Germany and Japan. Products on foreign exchange represent major currency pairs based on underlying spot prices. Binary options on commodities are available in metals, energies and agricultural markets. Additionally, binary option products on events such as the daily Fed Funds rate, Jobless Claims report and Nonfarm Payrolls numbers create an innovative way to position or hedge already existing positions that economic data may affect.
A new product that is catching on
NADEX, the North American Derivatives Exchange, Inc. is a regulated exchange located in the US that is the hub for binary option products. NADEX is a Designated Contract Market (DCM) and Derivatives Clearing Organization (DCO) and is subject to oversight by the Commodity Futures Trading Commission (CFTC). As an exchange and clearing organization, NADEX segregates all customer funds. Therefore, NADEX has the same structure as other traditional exchanges like the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE).
NADEX differs from other exchanges in that it offers binary option contracts and specialized spread products for very short durations. You can compare NADEX products to those offered in the past by the Midam Exchange only the NADEX products are smaller contracts making them more accessible for all market participants. NADEX does not compete with traditional futures and options exchanges rather its products compliment contracts offered on traditional exchanges. As such, binary option products will become integral and strategic tools for professional traders and retail customers alike.
The success of a new marketplace is highly dependent on liquidity. A narrow bid/offer spread and sufficient volume is necessary to attract the professional trading community. NADEX binary options offer benefits to a vast landscape of market participants.
An expanding audience for these tools
Market makers can use binary options to generate volume and trade against futures and options contracts on other exchanges creating arbitrage positions. Commodity Trading Advisors (CTA’s), Commodity Pool Operators (CPO’s), Associated Persons (AP’s) can all use binary option products to enhance and/or hedge existing positions. Fund managers, hedge fund managers and other financial professionals can add a new tool to their investment tool chest in order to enhance trading strategies. Retail clientele can employ binary option strategies to protect or create income against existing investments. On the retail side binary options are also excellent short term positional vehicles.
The opportunities are endless as binary options focus on risks for time horizons that other futures and options products do not specifically address. The success of binary option products depends on adoption by the infrastructure of trading and position management firms in the traditional futures business. Futures Commission Merchants (FCMs) are organizations that solicit or accept orders to buy or sell futures contracts, options on futures, retail off-exchange foreign exchange contracts or swaps and accepts money or other assets from customers to support such orders. Therefore, FCMs are important organizations in the world of futures and options trading.
An FCM often serves as a one-stop shop for traders and money managers. The FCM clears and maintains positions as well as manages margin and reporting requirements for its clients. The FCM stands in between traders, the exchange and the regulator. Binary option products, although regulated by the same CFTC, have not yet received support from the FCM community.
FCM’s are behind the curve
It is surprising that FCMs are so far behind the curve in terms of support for binary option products. Trading products- futures contracts and options, offered by the major exchanges are not competitive products. Those traditional contracts have a myriad of expiration dates, standardized delivery dates and generally trade from month to month. The NADEX binary option products trade for very short-term durations. Given the consistent availability of weekly, daily or shorter-term contracts, one would think that FCMs would be clamoring to offer clearing services for such vehicles to their customer base. After all, more trading, execution and clearing means more fees for the FCMs who are always looking for new revenue generating verticals. However, thus far customers who wish to add these binary option products to their trading toolbox must maintain two clearing relationships- one with the FCM who handles traditional products and one with NADEX for their products specifically. This becomes cumbersome for traders and money managers who need to focus attention on markets and strategy and keep administrative tasks to a minimum.
NADEX binary option products are trading actively, supervision and approvals are under the same regulatory umbrella, the products are useful to the traditional FCM customer base- so what are these companies waiting for?
What is holding up the process?
Since the financial crisis of 2008 and resulting regulations, new compliance duties have buried FCMs. FCMs have been executing, clearing and managing futures and option positions on exchanges for decades. Recently volumes in the futures business have been on the decline. More compliance responsibilities, less volume and a contracting industry have squeezed the profit margins for FCMs. Many of these companies are operating on very tight budgets and have cut staff. Perhaps this has resulted in a lack of focus on new products.
Binary options represent a new area for the FCMs- a new product for their customers and a new revenue source for themselves. My view is that once the first FCM adopts NADEX products and begins clearing them for their customers binary option trading will really take off and other FCMs will follow. The question is which brave FCM will step forward first?
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