Binary options are a clever financial instrument that allow people to make a simple 'higher' or 'lower' trade on the financial markets. Get it right, and you will receive a fixed return on your stake - generally 70, 75 or 80% for a successful trade, depending on the instrument and market conditions.
Get it wrong, and you lose your entire position.
These specialised instruments are classed as 'exotic options', with the most common being a 'high / low' option, where a strike price is set. It doesn't matter whether the instrument is just a fraction above the strike price or multiple pips when the expiry time is reached. if the player chooses the direction correctly they earn a fixed level of profit. Often these options use the terms 'put' and 'call', where a 'call' option indicates the player believes the price will rise, and a 'put' states the price will fall.
How to trade binary options
One of the reasons binary companies have had such success is they have simplified the complex world of financial trading down to a very simple yes/no choice. The way you 'trade' binaries is actually very straightforward: take a guess, hit the button indicating the way you think the market will move, and cross your fingers.
Options are set with a specific expiry period - popular options are 60 seconds, five minutes, one hour and occasionally one day. As the financial markets are so unpredictable in the short term, a sixty-second option is the highest risk for the player, while the longer term options do allow players to make an informed choice. If you play by the books and base your predictions on fundamental or technical analysis and set a long expiry time on your options you have a greater chance of not losing due to a random switch in market sentiments.
Unsurprisingly, for most players this is not the appeal of the instrument. They have been designed to be compulsive, addictive and exciting - patiently waiting hours for your positions to close is none of those things. Binaries are marketed as an extremely profitable activity, with gains of 400% or more in in a day. Some even promote profits of $500 an hour. It is difficult to reach these heights by taking the sensible, long-term view, so the majority of players win fast and lose fast, burning their capital within a number of days. We cannot emphasis enough: trading binary options involves a high level of risk. You can lose all of your capital surprisingly quickly.
What other types of option are there?
As well as the most common 'high/low' options, you can also opt for:
- Range options: If the price of the instrument falls within a certain range at the option's expiry, then the player wins
- One Touch options: In this case an instrument only needs to reach or 'touch' a specific price for the player to win, rather than needing to maintain a price above or below it.
Other variations include higher fixed returns, which could offer a higher reward:risk ratio - but with the caveat that it is likely to be harder to be successful with such an option than on a standard payout. Some brokers also allow traders to exit a position before it closes, which may limit their payout or losses but avoid the loss of the trader's entire stake.
How do the trading platforms make money?
Binary options brokers make money by fixing the odds so that over the long term a player will lose more than they win. A trade is effectively a position against the house, not a position on the market. In conventional trading you will buy or sell a currency, equity or commodity - or a CFD representing the same instrument - and profit or lose based on the change in value of that position.
By contrast with binaries you are simply taking a position against the broker, with no real exposure to the market. Therefore while CFD brokers and forex trading companies profit from the 'spread' and occasionally a commission, these sites bank your entire stake when you lose.
Why should I trade binary options?
There are a few key reasons why you might want to trade BO and not other financial instruments:
- They're great fun. The compulsiveness, the thrill of watching the charts almost but not quite hit your target - there's no denying they make great entertainment. Just remember if that's why you're trading, then it is entertainment, not an investment. Don't deposit more than you can afford to lose. Or sign up for a demo account instead of risking real money.
- They offer a fixed potential return. While this does mean your earnings potential is capped, it also means your losses are. You know upfront how much you stand to gain or lose, in contrast to trading CFDs or spread betting. If you can stop your emotions getting the better of you it could be a predictable way to speculate.
- Positions have a fixed entry and exit time. One of the challenges of traditional trading is timing your exit from a market to maximise winnings or limit losses. By setting a fixed expiry there is no need to make this difficult decision.
- There are no fees. While the broker will take a player's entire stake when they lose, there are no additional commissions, fees or spreads to pay on the price of an instrument.
- There are no liquidity issues. As the trader never buys the underlying asset the broker can offer a wide range of strike prices and expiry times to please the broker.
- There are no fixed trading hours. As the option is never traded on a market players can trade an instrument outside of normal hours, offering a wide range of assets and instruments from around the world. This isn't always a great thing - often it means you are simply competing against other traders on the same platform, not the wider market. The price is not representative of the open market which can increase volatility and risk.
Binary Options Vs Spread Betting
Spread betting and binaries share some of the same characteristics: you are trading against the house, not the markets. Profits are generally not classed as 'capital gains so there is no tax to pay in many jurisdictions, including the UK.
Binaries have become very popular for sharing these benefits of financial spread betting while simplifying the process of opening a trade. The key difference between the two approaches is that of your risk:reward.
In spread betting you can win back many times your initial stake should the market move in your favour, yet in the worst case should the market move against you, your losses could exceed your initial deposit. If you make a major loss you could be receiving a call from a debt collecting agency. This can be mitigated by using stop losses to limit the maximum loss, but in times of market meltdown you may find your broker does not honour your request.
By contrast with binaries you can only lose as much as you trade. But in most cases, you can't make a 'small loss' as you might with an appropriate stop loss - every time you lose you will lose 100% of the trade you put in. On the flip side your potential to profit is also limited, generally a maximum of 80% on top of your initial trade. But at least you do know how much you stand to gain in each case.
Why could binary options be a bad choice?
Our biggest issue with the industry is that it is largely unregulated and brokers - and the affiliates who promote them - frequently make outlandish claims about the potential for profits. For the majority of people who 'trade' it is not a carefully planned speculation but fun, fast and highly risky. If binaries were marketed as a form of entertainment akin to hitting the casino it would be different, but much of the current promotion of binaries as a grown up investment material feels at best deceptive, at worst fraudulent.
The industry is like the wild west - some of the bigger brokers are now regulated by Cysec, but with over 1,000 trading platforms in existence, it's clear the majority are totally unregulated. In the USA the securities commission has gone as far as issuing an investor alert, while the commodities and futures organisation have released fraud advisories to remind traders that the vast majority of companies are unregulated.
The risks of unregulated platforms are high: funds may not be segregated and transactions not monitored by third parties to ensure fair play. At worst this could mean a broker disappearing with your deposit or refusing to payout should you win.
If you decide to go with binaries, please make sure you pick a regulated broker. Aim to place longer-term options and plan your positions based on analysis, not instinct. Otherwise, please don't kid yourself that you are a trader or investor, enjoy the thrill but realise you are simply playing a sophisticated game of chance.