What Are Binary Options? – Definition
It is doubtful whether there has ever been a capital markets instrument that has had as much tosh written about it as the enigmatic binary option. The internet has been flooded with articles written by low quality ‘content writers’ lauding the simplicity of the instrument accompanied by ‘call-to-action’s. Unfortunately, some of these ‘call-to-action’s have been along the lines of “Enhance Your Pension” and other such irresponsible marketing that has given the binary options industry a bad name in some quarters. So exactly what are binary options?
Trading in binary options is not easy. That’s because, with money, traders also need a good strategy and understanding of the market. Otherwise, they might lose all their investment to someone else.
The next question that comes to mind is, why invest in a market that is so risky? Even though binary options are a risky market, you can make a large profit. You can do this by knowing about different types of binary options, scams, and risks.
As you are new to this market, you must do your research before trying your luck. And through this guide, we will answer all your questions.
What Are Binary Options?
Binary options are derivatives that make trade simple by turning it into a yes or no proposition. This fast-financial instrument has attracted various traders with its simplicity.
Binary options are all about predicting. As a trader, you have to guess whether the value of a commodity will increase or decrease. For example, you can predict the price of gold, Bitcoin, or a company’s stock price.
Based on your speculation, you can trade. For example, if you have predicted the value of a given item, you can make around 70-95% of the profit. That means if you have invested $100 and your speculation was correct, you can make a profit of $175 to $195.
But, if you miss the shot, you will lose all the money you have invest. It’s simple, and you will either make a great profit or lose the entire amount.
Traders are showing a great interest in binary options trading because it is easy. And it does not involve complicated math.
Furthermore, the expiry time can be as little as 60 seconds. Meaning anyone can trade several times a day throughout the world. Or it can be as long as a year.
Quick History of Binary Options
It’s essential to know about binary options history to understand this trading way in a better way. Binary options are not a new concept because it has been around for so many years.
When binary options trading started, only a few wealthy businessmen and large banks had access to it. But later in 2008, binary options trading became available for the public. And now, everyone can trade in binary options.
In 2007, the Options Clearing Commission wanted to make changes to the trading concept of binary options. So, a year later, the US Securities and Exchange Commission made binary options available for public trading.
Types of Binary Options
Till now, you might have understood that binary options are about predicting whether the price will be higher or lower at a specified time. But there is more to the story.
Here are a few popular types of binary options that can lead a trader to different levels of risks and returns.
Up/Down (High/Low) Options
Most of the binary options trading scenarios can be boiled down to the concept of Up/Down. The basic principle of this trading type is to predict the price of an asset from the time of investment to its expiry period.
At the time of buying an asset in binary trading, its value is called the spot price. Now, here are two conditions.
Either the value of an item will increase from its spot price, or it will decrease. So, you have to predict the price movement. If you are assuming the value will go up, you can buy a call option. But if you are predicting the price to go down, buy a put option.
Example of How Up/Down (High/Low) Options Works
Let’s assume you are trading on EUR/USD currency pair. For this, you are investing an amount of $200, and the expiry time is 30 minutes.
To trade, you need to simply guess if the price of EUR/USD will go down or up. Now, you assumed that the value of this currency pair would decrease in half an hour, and you place a put trade. If your assumption is correct, you will win $275.
But if the value of EUR/USD has increased in the given expiry time, you will lose the entire amount.
Touch/No Touch Options
In the Touch/ No Touch option, a trader has to guess whether the price of a commodity will be higher or lower than the pre-decided value.
One thing you should remember in the touch option is that here value is fixed by the broker. That means you cannot predict any specific price. Instead, you have to assume a correct situation.
In the touch option, you assume that the commodity’s price will touch the strike price. And in no the no-touch option, you assume that the commodity’s price will not touch the strike price.
Example of How Touch/No Touch Options Option Works
Again, you are trading on USD/EUR currency pair. The value of this pair is 0.8934. Before trade starts, the broker fixes the strike price around 0.8939.
If you assumed that the price of currency pair would increase and it did even for a short period, your trade is successful. Meaning you will get more than what you have invested.
Even if the price is less than the strike price after the expiry period ends, you will profit because it has touched the target level.
Boundary trade, also known as In/Out trade, is mainly about predicting whether the price of an asset will be In the pre-established range or it will go Out. As compared to the other two trading options, this one offers a better return of 100%.
This trading technique is commonly used in the flat market. That’s because, in a flat market, big price swings can’t be predicted.
Example of How Boundary Options Work
Suppose you are trading on gold, and its current value is 0.8935. Its predetermined top value is 0.8940, and the button value is 0.8930. The expiry time is 30 minutes. Before the expiry time, you trade In, and the price stays within the given range. This means that you have made a profit.
This binary trading option is quite innovative because here, the broker sets different limits. Furthermore, this trading is represented in the form of a ladder, where rungs show different price levels set by the broker.
If you are trading using ladder options and have made the right assumptions, you can earn up to 1,000% profit. Even if you are partially correct, you will make a partial profit.
How do Binary Options work?
As we have already explained binary options, here’s how it works.
To trade correctly in binary options, you need to make the right assumption of an asset’s value. When expiry, if the actual price of an asset and your prediction is the same, you will make a profit.
The gain or loss amount will be directly credited or debited from your account. With binary options, you can trade either in forex, commodities, stock indices, or events.
How to Trade?
As you have understood how binary options work, here’s a little step-by-step guide on how to trade binary options perfectly.
Choose a broker
To make a profit by trading in binary options, you need a skilled broker on your side. But beware when you find one because there are several unlicensed operators. Make sure you avoid all the brokers who are blacklisted.
Before signing up for any broker, you must check a few things. Like you should check the least deposit criteria, assets offered, fees, regulations, demo accounts, applications, and extra features.
Pick an instrument
Once you have found a trustworthy broker and signed up, the next thing you need to do is find an instrument.
It would be great if you select an instrument (a market) you are familiar with. That’s because a familiar market can help you make more profit.
If you want to trade in the forex market, the broker can offer you different currency pairs like GBP/USD, USD/JPY, and EUR/USD. You can even trade in oil, silver, or gold.
But if you are interested in stocks, remember that brokers can only offer you a limited number of stocks for trading.
Select Expiry Time
After choosing the right market, you can select an expiry time. This is a crucial step because you need to analyze the price movement of an asset in balance with your trading value.
There are three types of expiry times you can choose from, i.e., short term, normal, or long term. The short-term expiry time is generally less than 5 minutes. Normal expiry time can be as low as 5 minutes, and it can last up to the end of the day.
The long-term expiry time is beyond the end of the day and can last up to a year.
Set the Trade Size
It’s essential to decide the amount you want to invest because the bigger you trade, the better you will earn.
At the same time, you need to remember that your entire invested amount is also at risk, and you may lose it all.
Select an Option
Lastly, you should select a trade option. If you want to play safe, choose the High/Low option as it’s less risky. Moreover, it can help you make a decent profit. But if you are ready to take a bigger risk, you can trade using the ladder option.
No matter which trade option you choose, you must carefully analyze the market and understand the price movement. Larger profits might be appealing, but it also comes with more risks.
Binary Options Scams
Trading in binary options has become risky as scams by deceitful companies have increased in this market, especially for newbie traders.
Traders who have a limited understanding of binary options trading often fall prey to fraudsters. But not anymore because here are a few common binary options scams and ways to spot them.
- Marketing “Too Good to Be True”
Markets promising larger profits is appealing, but it might jeopardize your investment. But you can make your bets safer by not trusting such marketing that are too good to be true.
- Cold Calls
Any form of unsolicited approach is considered a cold call. This is divided into two categories. The first is when you receive an unknown call asking you to join any platform. And the second one is when you receive a call or email from a senior authority. For example, through email or call, fraudsters might ask you to invest in a particular trade.
- Channel Sales
If you are redirected to another broker’s website, you should stay away. That’s because the funnel sites are designed to dupe visitors.
- Deposit Bonus
A deposit bonus sounds reasonable but legitimate companies mostly never offer a deposit bonus to any trader.
Risks in Binary Trading
With great investment comes great risk. Of course, you can make a huge profit by investing in binary options, but that’s just one side of the coin.
If your prediction is not correct, you might lose all your investment. Besides this, binary options broker also does not offer enough technical tools to the traders.
Moreover, the amount you get after winning is comparatively lower than what you are expecting it to be.
Binary Options Regulation
One of the main problems when considering the regulation of binary options is defining what a binary option actually is. Unfortunately for the regulator, as the below will explain, this is tantamount to asking how long is a piece of string.
Only when a workable definition of a binary option is generated can the instrument be successfully regulated.
A Possible Workable Definition
A binary option is a derivative that:
- is based on the price of a capital market or insurance market asset
- has a payout bound by 0 and 1 inclusive, or multiples of 10 thereof.
A seemingly nice and simple definition one may think yet the following will all confuse the issue:
- underlying asset
- price format
- time to expiry
- the user interface itself.
All Capital Market Instruments are Binary Options!
Any other capital market instrument can be replicated by a structure of vanilla binary options, i.e. all capital market instruments could be viewed as binary options. Far fetched? There is a direct corollary in computer software. The software languages that are more readfily known to us and that can be seen under the ‘Computing’ shelves of a bookshop, e.g. VBA, C, Java, Ruby or Erlang are all user-friendly manifestations of machine code, the basis of which are the binary numbers 0 and 1.
A conventional option can be replicated by a structure of vanilla binary calls and so can a conventional call spread as attested by the IG Group’s Nadex. The CFTC are happy with Nadex’s interpretation of a conventional call spread in the guise of a binary options strategy, yet this is just the tip of the potential iceberg.
A limit-up, limit-down future can be replicated by binary options. Furthermore, a barrier option itself is a ‘Yes’/’No’ event thereby dragging the most sophisticated market of all, the interbank FX market, into the realms of binary options trading.
Unless the regulators of binary options understand the reach of binary options within the capital markets industry the regulator is likely to create confusion which in itself could possibly lead to regulatory arbitrage.
The following are elements that could, and possibly should, impact on the regulation of binary options.
The Underlying Asset
The likeness between a bet on a horserace and whether gold will be above or below a particular price in the future are obvious. The first part of the above ‘A Possible Definition’ puts a clear limit as to the boundary of a binary option and differentiates between a fixed return bet on, for example, a sporting event and a capital market event.
The insurance market has been included since an Industry Loss Warranty (ILW), generally a vanilla binary option, is already a well-established and accepted derivative primarily traded between the insurance and reinsurance companies.
In the US the scope for trading derivatives on film industry box office receipts has been examined. At present the underlying asset has been rejected by the CFTC although for the film industry itself the hedging process offered by these specific derivatives has clear commercial value. In the future what may or may not be considered a capital market asset could of course be changed.
The Nadex interpretation that a binary option can settle at any price between and including 0 and 1 (and multiples of 10 thereof) has created a powerful precedent.
On mainstream derivatives exchanges the ratio of the volume of conventional vanilla call and put options is possibly just 20% of the total volume, the other 80% taken up by conventional options strategies such as call and put spreads, straddles, strangles, butterflies, condors, etc.. It is likely that as the binary options market develops then structures of binary options will rule the roost also. Should that be the case then the CFTC view of a binary options should be upheld, i.e. a binary option strategy does not need to settle solely at 0 or 1 can be allowed to settle at any intermediate value as well.
The price constraints of the binary option’s 0 and 1 are often (quite rightly) equated to the probability of the event happening or not.
All sports bookmakers and betting exchanges offer odds based on the numbers between 0 and 1, inclusive. The word ‘Evens’ equates to the binary options price (probability) of 0.5. In a similar manner the odds 4/1 equates to the binary options price of 0.2, while 6/4ON equates to a binary options price of 0.6.
For retail customers on the internet binary options are often presented in a percentage return format so the binary options price of 0.5 would be presented as a 100% return investment.
Continental prices (those offered by, for example, Betfair) would show a price of 3.0 for a binary options price of 0.3333, while showing a price of 2.0 for a binary options price of 0.5.
Binary options providers often multiply the 0-1 binary options price format by 100 so that the payout is now ranging between 0 and 100 inclusive.
The critical features of the price format is that they are:
- bound by a representation of 0 and 1 inclusive, and
- understood by the end-user.
If the non-mathematician is more comfortable investing at a price of 4/1 (as opposed to 0.2) that the FTSE will be above a certain price then that price of 4/1 should be allowed to stand as the alternative could well be that the non-mathematician invests at a price of 0.2 they do not understand.
Time to Expiry
The short-term nature of the length of contracts of the internet-based retail binary options has generated a certain amount of ill-founded comment that this alone renders the instrument a gamble, a bet, as opposed to an investment.
Firstly, as an ex-pit trader on LIFFE, CBOT and the SFE I have been able to watch the extraordinary capability of certain ‘local’ traders (independent traders trading with their own money) to forecast ultra short-term movements. When the exchanges went electronic these traders were replaced by a new breed of ‘local’ who sat at a desk watching price movements, or ‘price action’, on a screen. I did not have this ability (I was a ‘local’ options market maker) so what may have been a gamble to me was a ‘nailed on cert’ for these other guys.
Nowadays the markets are dominated by High Frequency Traders using ultra fast algorithms and execution to take and exit positions in the market. These operations can enter thousands of different orders across a range of different assets only to reverse them all within seconds. Across the globe regulators view these actions as investing, not gambling.
The current short-term nature of retail binary options should not be jeopardized by enforcing a rule (such as the Japanese FSA has done) of creating a minimum length of contract (one hour in Japan) that serves no real purpose at all. If the JFSA were questioned on this limit of one hour one might wonder what their rationale was.
An expert in the field of gambling regulation recently proposed to me that binary options were gambling because of the limited risk aspect of the stake purchased which, in effect, was pursuing an argument that the premium was much the same as a gambler’s stake, it could all be lost. This argument is clearly flawed by the fact that a buyer of conventional options would also be gambling and therefore conventional options should fall under a betting regulator as opposed to a financial services regulator.
Not one of the binary options providers took a hit in the recent Swiss/Euro debacle in January while notable names, such as the IG Group, took a sizeable battering on their non-binary offerings. Since the UK taxpayer underwrites the clients of UK FCA regulated firms (via FSMAs Financial Services Compensation Scheme) there is good reason for the FCA to ensure that all firms have adequate resources to take a hit; yet overly punitive capital adequacy requirements for limited downside risk binary options companies will likely be counter-productive as companies determine to be offshore, thereby resulting in unregulated entities and the loss of revenue to the UK from these outfits. (The UK’s FCA has been used as an example as they are in the process of delivering regulation on binary options but the tenet of the argument applies to all mainstream onshore financial regulators.)
Innovative trading interfaces are constantly drip-feeding onto the financial markets as designers compete to come up with the most attractive compromise between ease-of-use and providing sufficient market data. What if a designer came up with a radical new interface whereby the market is traded in the form of a cricket match or a game of snooker? How about a casino-themed interface to trade the market? If the underlying asset of these ‘themed’ sites is still a capital market asset is that sufficient to determine that it is a binary option or is there a predetermined notion that a binary option has to be offered in some more traditional (tired) manner?
Say I wish to offer binary options in the form of a game of seesaw? At-the-money calls and puts can easily be presented in this dynamic, graphic format. Is this depiction of a capital market asset gambling?
The regulation of binary options is going to be challenging, especially should regulators decide that the simple definition of a binary option does not fall into line with that proffered earlier in this article.
The current purchase of Plus500 by Playtech is underscored by the blurring of the demarcation between capital markets and the gambling markets. The fact that Betfair offers some financial bets as well as sports bets is yet another example of these two sectors treading on each other’s toes.
In the UK, if the FCA gets this regulation right then it would almost definitely be the first port of call for binary options operators that are looking to play with a straight bat. The FCA’s approach could well be the shake-up the European binary options so desperately needs.
Before you start trading in the binary options, you must know about the general risks and scams. For a risk-free trading experience, initially, you should trade in a demo account. You should do this so that you can get the hang of how binary options trading is done.
You should never buy and hold an asset for a long time because doing this might make you lose more money.
All in all, investing in binary options is an excellent way of making more profit in a limited time.