In some respects, any time one trades equities, futures or options, one is making a bet. Sophisticated traders sometimes employ theories such as "Risk of Ruin" borrowed from the gambling world, pointing out the similarities to the chagrin of those among us who like to think of ourselves as business people rather than gamblers.

However, among the option world, a couple of types of options seem more closely linked to the gambling world than others. I'm speaking of binary options and event options. Binary options pay on an "all or nothing" setup that pays a fixed amount, typically $1.00 times the 100 multiplier, if certain conditions are met. We've almost all heard of binary options related to specific events: the outcome of an election or other such events. However, in 2008, the CBOE rolled out binary options on the SPX and VIX, with those options paying out a fixed $1.00 times the 100 multiplier if the underlying settles at a certain level or nothing if it doesn't. The symbols for the underlying for these options are the BSZ and BVZ, respectively. Only calls were offered at first, but the CBOE added puts about a year ago, only a few months after the calls were first introduced.

Both are European-style options and settle when the SPX and VIX settle, and remember that the VIX settlement is non-standard. The can be exercised only on the last business day prior to expiration. The use the settlement values of the SPX and VIX for each option-expiration period.

I'm a little worried about downside potential for equity markets right now, but let's say that someone else is bullish and believes that after the current pullback that's underway, markets will shoot up again. That someone wants to bet that the SPX will end October's expiration above 1100. That can bet can be placed in two ways. The standard way is to buy a call option on the SPX with a strike price at or below 1100, so that option will be in the money at expiration. For example, on Friday, September 18, 2009, the mark or mid-price on an SPX OCT 2009 1100 call was $10.10. With the 100 multiplier applied, a trader who'd been able to buy at the mid-price would have spent $1,010 plus commissions for that purpose. As this article is edited, the current mark or mid-price for that option is $4.70, worth $470 minus commissions. Ouch.

Another way of betting that the SPX would end up above 1100 at October's expiration would have been to buy a BSZ OCT 2009 1100 call, with a mark or mid-price of $0.28 at the time. With the 100 multiplier applied, a trader who'd been able to buy at the mark would have spent $28.00 for that bet. As this article is edited, the current mark or mid-price for that option is $0.21, so that the option would be worth $21 minus commissions. Not as big an ouch.

What's the difference? The difference lies in the binary option's all-or-nothing setup. If the SPX settles at or above 1100 at October expiration, the binary option pays a fixed amount of $1.00 per contract, times the 100 multiplier, of course. If it settles below 1100, it pays nothing.

The SPX version of the 1100 call also pays nothing on expiration if the SPX settles below 1100. It also pays nothing if the SPX settles exactly at 1100. And, if the SPX settles at 1101, the SPX and BSZ options pay the same $1.00. However, if the SPX settles at 1110 on October's expiration, the SPX 1100 call is worth $10.00 times that multiplier or $1,000.00, while the BSZ 1100 call is still worth only the fixed amount, $1.00 times the multiplier, or $100.00.

Another difference--one that offers caution for anyone employing anything other than lottery money to buy one of these options can be found in volume and open interest figures. On September 18, 2009, volume and open interest on the SPX OCT 1100 call were 10,690 and 90,093, respectively. For the BSZ OCT 1100 call, the same brokerage listed N/A and 0 for those calls. The BSZ OCT 1150 call listed volume and open interest of 2,000 for that day, but so did the BSZ OCT 800 calls.

Hmm. A July 9, 2008 Lehman Brothers white paper on binary options claimed that the "cleanest way of implementing the view that the underlying remains within a defined range" would be to buy a lower strike binary SPX call and sell a higher strike one. Do you think that was happening with those matched volumes of BSZ OCT 800 and 1150 calls? Volume was almost non-existent for most BSZ options in both the OCT and NOV expiration cycles, so that matched volume is a bit eye catching, inviting speculation on what's up.

Therein lies the most frequently mentioned caution with regard to the binary options: liquidity. Another drawback is that not all brokerages offer these products. The CBOE lists 16 brokerages that offer them, but mine is one that is listed, and I can't find these options quotes on my brokerage. Think-or-Swim is listed on the CBOE's page and they do appear to be offered on that platform.

The CBOE's product pages also caution that spread margin requirements and short straddle/combination margin requirements differ from those using standard options. When I tested a bear put spread order on Think-or-Swim's Paper Money platform, I got a warning that I should "Please note that you have selected a 'non-standard' option series and there may be liquidity and settlement risks that you are not aware of." That test order was for 10 contracts of a BSZ OCT 1025/1000 bear put debit spread (buying the 1025 put and buying the 1000). If the SPX ended OCT's expiration at or below 1025 but above 1000, that spread would bring profit of $1.00 x 100 multiplier x 10 contracts = $1,000 minus $39.95 in commissions. It would have cost $109.95 including commissions to open with a buying-power effect of $70.00.

Would these binaries prove helpful in cheaply insuring a long-delta portfolio against a steep decline in prices or a short-delta one against too strong a climb? Interesting question, but I don't know the answer. I'm not going to employ this strategy without more information, and I'm certainly not suggesting it for our subscribers.

I believe TOS when it mentions liquidity issues and I certainly don't understand enough about these options to know what I don't know about them! If you decide, despite the drawbacks of these options, that you should want to place a bet using binaries, discuss the issues TOS and the CBOE mention with your broker.

The Lehman Brothers paper mentioned in this article lists other possible and exotic uses for binary options, with this paper accessed through the CBOE's product pages on binary options. For example, one chart was titled "Implementing a More Risk Controlled Volatility Selling Strategy" which was described as a cumulative profit/loss chart for a strategy of going long a 10 percent ITM SPX Binary Call. However, most experienced traders I've heard from have so far shied away from these products because of the shortcomings listed above and I suggest you do, too, unless you've answered these questions to your satisfaction.