An extremely helpful side effect of the pricing and payoff structure of a binary option (such as a Fixed Return Option, or FRO) is that the bid and ask both represent the probabilities the buyer and
seller assign to an event happening. Binary options paying $100 or $0 depending on whether or not the government will pass a “bailout bill” for the financial system before the end of September, for example, last traded at $65 – meaning that
this market is assigning about a two-thirds chance such legislation will be passed. The market pricing of these useful instruments, then, allows everyone to see the odds people with conviction enough to bet real money – not just TV pundits – have an event will occur.
In the financial space, the FRO market on individual stocks allows us a glimpse into what price traders believe the referenced security will be at on a certain date. One of the most watched stocks of late is investment bank-turned-regulated bank Goldman Sachs (ticker: GS), which has stood strong even as rival firms have collapsed. The crisis of confidence gripping the financial system, however, threatens even the best of firms with liquidity shortages – one reason Goldman Sachs recently recapitalized to the tune of nearly $10 billion in new equity. With this new liquidity and a wide-open competitive landscape, is Goldman poised to emerge on the other side of the credit mess with tremendous earnings potential, or is it destined to be brought down as well?
The following two charts were constructed from the bids on a range of front-month (October) FROs on Goldman Sachs. This diagram from the long perspective (betting whether Goldman will finish at or above the specified strike price) using the Finish High FROs says that traders believe the current $133 price is essentially a coin flip.
But the following chart from the bearish perspective made using Finish Low FROs suggests that the pessimism about downside risk does not match with the indecisiveness bullishness. Traders are saying that the “50%” price is $145 – meaning they believe there is a 50% chance Goldman Sachs finishes under $145 at contract expiry – or almost 9% higher than Goldman’s current stock price. In fact, the odds say there is less than a one-in-three chance Goldman’s stock doesn’t increase between now and expiration, and the odds of a large decline show a marked drop-off.