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Binary options are a clever financial instrument that allow people to make a simple 'higher' or 'lower' bet on the financial markets. And a bet it is - as much as brokers like to position themselves as an investment option you are effectively participating in a fixed odds casino. Get it right, and you will recive a fixed return on your stake - generally 70, 75 or 80% depending on the instrument and market conditions.
Get it wrong, and you lose your entire stake.
Binary options 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 guesses the direction correctly they win a fixed reward. 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.
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 though, for most players this is not the appeal of the game. Binary options have been designed to be compulsive, addictive and exciting - patiently waiting hours for your postiions to close is none of those things. Binaries are marketed as an extremly 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.
As well as the most common 'high/low' options, you can also opt for:
Other variations include higher fixed payouts of up to 500%, which could offer a higher reward:risk ratio - but with the caveat that it is likely to be harder to 'win' 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.
Binary options brokers make money in much the same way a casino does - by fixing the odds so that over the long term a player will lose more than they win. A stake is effectively a bet 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 placing a bet 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, binary options sites bank your entire stake when you lose.
There are a few key reasons why you might want to trade binary options and not other financial instruments:
Spread betting and binaries share some of the same characteristics: you are betting against the house, not the markets. Profits are generally classed as 'winnings' not capital gains so there is no tax to pay in many jurisidictions, including the UK.
Binary options have become very popular for sharing these benefits of financial spread betting while simplifying the process of placing a bet. 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 stake. 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 stake you put in. On the flip side your winnings are also limited, generally a maximum of 80% on top of your initial stake. But at least you do know how much you stand to win or gain in each case.
Our biggest issue with binary options is that the industry 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' binary options it is not a carefully planned speculation but a fun, fast and risky bet. 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 brokers 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 brokers are unregulated.
The risks of unregulated brokers 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 regualated 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 in a casino playing a sophisticated game of chance.