One of the major concerns for individual investors is the security of their money, and it often impacts what investments they choose. While Treasury bonds and bank deposits guarantee a high level of capital security, equities and mutual funds carry the risk of losses, which can largely affect invested capital. Derivative products like options and futures carry much higher level of risk, as one can lose more than just the invested amount.

Many mutual fund firms cash in on this with the concept of “capital protection,” and some have launched capital guarantee funds and principal protected notes (PPN). These products provide upward return potential, while guaranteeing the preservation of the invested amount. Interestingly, individual investors can combine binary options with bonds to create similar capital-protected investment (CPI) products on their own. There are no fund management charges to pay, and you can decide how to configure it.

This article assumes basic familiarity of the reader with options.

Quick Intro To Binary Options

Binary options are popular trading instruments having a unique "all-or-nothing" payout structure. With the New York Stock Exchange introducing its own version of binary options under the name Binary Return Derivatives (also called ByRDs), the popularity of binary options is expected to gain further momentum. (For more, see: Intro to NYSE Binary Return Derivatives.)

Based upon whether the settlement price of the underlying ends above or below the strike price, the return from a binary option is finalized. Assume you are purchasing a binary call option with strike price of $50 on an underlying stock by paying an option premium of $33. If the underlying price settles above $50 on the expiry date, then the buyer will get $100 as binary option payoff (“all”). If it ends at or below $50, buyer gets no payoff (“nothing”).

In the former case, the binary option buyer’s net profit is $100 (Payoff) - $33 (Premium Paid) = $67. In latter case, he suffers a loss of $33 as his binary option expires worthless, and he gets nothing. (For more, see How The New NYSE Binary Options Work and A Guide To Trading Binary Options In The U.S.)

Let’s see how capital-protected investments can be created using binary options. Assume Mike has $2,000 that he wants to invest for higher returns, but he also wants some protection for the initial investment.

The Capital Protection

U.S. Treasury bonds provide guaranteed risk-free returns. Assume a one-year Treasury bond offers a 6% return.

Bond returns are calculated using the formula:

Maturity Amount = Principal * (1 + Rate%)Time,

where Rate is in percentage, and Time is in years.

Investing $2,000 in this bond for a year will get Mike a maturity amount of:

Maturity Amount = $2,000 * (1+6%)^1 = 2,000 * (1+0.06) = $2,120.

For Mike to preserve his capital of $2,000, the above formula can be reverse engineered. He essentially needs to answer this question - How much should I invest today to get $2,000 as a maturity amount after one-year?

Here, Maturity Amount = $2,000, Rate = 6%, Time = one year, and we need to find the principal.

Rearranging the above formula: Principal = Maturity Amount / (1+Rate%)Time.

Principal = $2,000/(1+6%)^1 = $1,886.8.

Investing $1,886.8 in the above bond will secure Mike’s capital, since he will get $2,000 at maturity.

The Upward Returns

The remaining amount ($2,000 - $1,886.8) = $113.2 can be used to purchase binary options, which offer high return potential. Assume Mike believes that ABC Inc. stock currently trading at $30 has the potential to hit $55 in one year’s time. A binary call option available on this stock with one year to expiry and $50 strike price is available at $37. He can purchase three such binary options totaling $111, which fits within the available money ($113.2).

If Mike’s assumption comes true, and ABC stock reaches $55 (or even just above $50), each of his binary option will give him a $100 payoff ($300 for the three binary options). His total return from bond and binary option comes to ($2,000 + $300) = $2,300. On his total invested amount of around $2,000, his net percentage return comes to ($2,300 - $2,000)/$2,000*100% = 15%. In this case, his capital remains preserved and he also earns excess returns.

If Mike’s assumption turns false, and ABC's stock isn’t able to cross the strike price of $50, then he loses his option premium of $111. In this case, he loses out on the excess returns, but his capital remains protected.

In both the cases, the capital remains protected. Potential of an upward return comes from the binary options, which may or may not lead to high returns.

Variants and Drawbacks

Though similar ready-made products may be available from fund houses in the market, they might come at a high cost and might not fit into an individual's choice of investment horizon or underlying assets. Creating such capital-protected investment products allows individuals the flexibility to go for their choice of underlying security, investment horizon, or bonds.

If you have a bearish view on a security, you can purchase binary put options that give positive returns on the decline in underlying price. Other variants can include limiting the level of capital protection from 100% to lower - say 90%, 80% or 50%. This will leave more residual money available for buying binary options, which will lead to higher return potential. However, since this comes at the cost of reduced capital protection, you should configure the combination according to your own risk appetite.

A subset of the above is to spread the residual money across multiple binary options on different uncorrelated underlying stocks. This increases the return potential, as at least one (or a few) binary options on different underlyings may provide higher returns. However, you should be careful about high transaction costs that may eat into profits.

Options trade in lots, and you may not always get exact number of options required for the calculation. Ignorant investors also get into a tendency of buying highly risky options at high price, which often result in no returns. Though the capital appears to be protected, the opportunity cost of the capital leads to a loss. The hidden inflation combined with the opportunity cost reduces the real value of capital over investment horizon.

The Bottom Line

Options are often perceived as high-risk instruments, but their efficient use, with careful consideration and the right combinations, can yield improved returns. Capital-protected investments using binary options can be easily created by individuals on their own. They offer a balanced and efficient alternative to risky stocks and mutual funds, as investments in the latter often result in capital losses.

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