Risk Management

Conventional options are the most heavily exchange-traded option, yet
volumes rarely exceed that of the underlying future with one or two
exceptions (e.g. the Kospi index). This can be partly explained by the endusers’
reticence in using a complicated instrument, but the major constraint
is the reluctance of brokers to offer accounts to many customers who may
not be capable of sustaining the potential losses that can be incurred from
losing positions. These losing scenarios will always be predicated on the
naked writing of options that occasionally explode, leaving the short with
a potentially limitless, unrecoverable debit on his account.
In contrast to the above high-risk situation, the binary option enables all
potential losses to be calculated on the inception of the trade, since the
price of a binary option is constrained by the limits of 0 and 1. As we will
see later, writing (selling) a binary call has the identical profit & loss (P&L)
profile of buying the same strike put of the same series. On selling an
out-of-the-money call at 0.2 (equivalent to a 4/1 bet) the seller’s maximum
loss will be at 1.0, where he will lose four times the amount he sold.
Clearly the broker is likely to have less unease in opening accounts for
clients with this scenario; and if the broker insists on 100% upfront
payment of the maximum potential loss, then the broker’s potential
liability is now totally covered.