Range Options (Boundary Options)
Many new exotic currency options have sprung up during the last five years primarily to create payoff and risk profiles that are attractive for specific user constituencies. A simultaneous endeavor has been the search for options premiums that are lower than those incurred with traditional put and call options. Among the variety of exotic options that have accomplished these objectives and which have become popular are barrier options and digital options.
A recent newcomer that combines the characteristics of barrier and digital options but that produces its own unique payoff and risk profile is the Binary Range Option.
A Range Option is neither a call nor a put option but rather an option that gives the holder a specific amount (payoff) if the underlying currency remains within a predetermined price range (Boundary) by the expiration of the option. Typically, the Boundary levels are set above (Upper Boundary) and below (Lower Boundary) the currency’s spot price. However, if the Boundary levels are touched at any time prior to expiration, the option ceases to exist.
Binary Range Options are attractive holdings for investors who believe that a currency will remain within a given trading price and are willing to risk a known and predefined premium for a specific maximum return. Thus, both the maximum potential gain (payoff) and premium (risk) are known in advanced.
Another important attribute of Binary Range Options is that they are one of the few structured options that allow the holder to benefit from a decline in the volatility of the underlying currency without the necessity for writing options. Moreover, they are simple in construction as well as easy to understand, monitor and calculate the payoff return. In addition, customization of the Boundary levels provides for the ability to engineer an option premium that is affordable for a client.
There are a number of important benefits for using Binary Range Options.
The first is the ability of a buyer of Binary Range Options to profit from a reduction in volatility. With traditional put and call options it is only the seller of an option who can benefit in the event volatility contracts. Dealers usually restrict the selling of options to suitable and qualified clients and frequently request sizable capital requirements as well as high credit worthiness. Binary Range Options offer the buyer similar benefits that sellers of traditional options may avail themselves of without the necessary higher suitability or credit requirements.
The premium paid for a Binary Range Option is dependent upon seven primary elements:
1. Spot Price of the currency
2. Domestic interest rate
3. Foreign interest rate
4. Time to maturity
5. Volatility of the currency
6. Up and Down Boundaries
7. Trade Amount
For Example:
USD/DEM Spot = 1.50
DEM Libor = 3.4%
USD Libor = 5.9%
Time to Expiration: = 92 Days
Volatility = 12.5%
Boundaries = 1.40 and 1.60
Amount = 1,000,000 DEM
Binary Range Option Premium = 422,863 DEM
Payoff results for Binary Range Options are most similar to the combination of buying a spread and selling another spread. However, there are important attributes to Binary Range Options. The first is that there is only one transaction to monitor instead of a series of different options. The second is the fact that as time passes the option increases in value. The graph illustrates the value of the Binary Range Option in seven different time intervals that end at the expiration date. The shorter the time to expiration and the further the distance from the boundaries, the higher the value of the option.