HedgeStreet: The boldest derivative contract

What is HedgeStreet?

It is an Internet-based government regulated derivatives exchange where traders can hedge against or speculate on economic events and price movements.

HedgeStreet targets retail speculators and hedgers by offering $100 contracts. The Chicago Board Options Exchange  owns a minority interest in HedgeStreet that offers a variety of contracts designed to give private individuals the ability to manage the particular risks they face.

HedgeStreet's contracts span a range of markets, from commodities and currencies to economic indicators, employment, fuel, housing prices, inflation, hurricane insurance estimates, and interest and mortgage rates. HedgeStreet members can use the site to put in order entries, find out about market depth, historical data, and position reporting.

Although the liquidity on HedgeStreet contracts is low, as a regulated exchange that offers binary option contracts--a contract format that they pioneered--they do add value in the derivatives marketplace.

Liquidity for the exchange has recently risen due to the $10 million investment by market makers Susquehanna International Group and DRW Trading Group in March of 2007.

Based in San Mateo, California, the company is subject to regulatory

oversight by the Commodity Futures Trading Commission. Membership is only open to people residing in the United States. Member funds are held at the Union Bank of California.

What is a Binary Option?

A binary option is a type of option where the payoff is either a fixed amount of some assets or nothing at all. Two main types of binary options are the cash-or-nothing binary option and the asset-or-nothing binary option. The cash-or-nothing binary option pays some fixed amount of cash if the option expires in-the-money while the asset-or-nothing pays the value of the underlying security.

Thus, the options are binary in nature because there are only two possible outcomes. They are also called all-or-nothing options or digital options.

For example, suppose I buy a binary cash-or-nothing call option on XYZ Corp's stock struck at $100 with a binary payoff of $1000. Then if at the future maturity date, the stock is trading at or above $100, I receive $1000. If its stock is trading below $100, I receive nothing.

In the popular Black-Scholes model, the value of a digital option can be expressed in terms of the cumulative normal distribution function.

Srinivasan Venkataraghavan is Chief Executive Officer, Altos Advisory Services