Many investors are unaware that CBOE lists binary options on SPX and VIX (www.cboe.com/binaries). A binary call option pays a fixed amount ($100) if the settlement price is equal to or greater than the strike.
Binary options have become popular in the structured product market as well as the fixed indexed annuity space. Banks and insurance companies have been issuing products that have embedded binary optionality. Today we’ll examine one such structured product and discuss how its payoff can be replicated with CBOE FLEX® options.
The structured note being analyzed was issued by a large global bank last month; it was featured in a recent issue of Structured Retail Products Magazine. It has a 4-year duration and is tied to the S&P 500. It offers a 10% buffer, meaning that investors are protected from loss on the first 10% decline of the index; as the index falls more than 10%, investors experience a dollar-for-dollar decline along with the index – this is not a principal protected note. Further, the note pays 20% if the index has a positive gain over the investment period (this is the binary aspect). Moreover, above 20%, investors would experience a dollar-for-dollar gain along with the index. So how can we replicate this payoff with FLEX options?
- Sell 1 European-style XSP (i.e. mini-SPX) 90% put at $17.00 expiring in 4-years
- Buy 1 European-style XSP (i.e. mini SPX) 120% call at $9.00 expiring in 4-years
- Buy 26 European-style SPX binary options (ticker = BSZ) 100% calls for $0.36 expiring in 4-years
*Execution prices are indicative only
The above package of options results in a net debit of $1.36. It requires $13,523.40 if executed in a cash securities account (reference 1,298.60 on SPX). The payoff profile looks like this (virtually indistinguishable from the payoff profile of the structured note):
Consider combining CBOE binary options with other FLEX options to create some interesting payoff profiles.