The Complete Guide
Learn about the world of binary options. Should you engage in this trading activity, and if you do, how would you steer away from binary options scam, and focus on reliable providers.
What Are Binary Options?
And Why Are They Considered So Risky?
A Binary option is a type of option where the payoff is some fixed amount or nothing. For example a $100 option with 75% payoff, will payout $175 if the trader wins and nothing if the trader makes the wrong call. When you purchase a binary option the potential return is stated before the trade is opened. It is possible to offer Binary options for almost any tradable financial product. Binary options also allow a trader go either long or short, to take a long position a trader buys a call option and to go short a trader buys a put option.
Binary Options are available as both an exchange traded product and as over-the-counter non-exchange traded product. US residents are only allowed to trade Binary Options through US regulated exchanges. In Europe non-exchange traded Binary options have become very popular since a number of online platforms begun to introduce them back in 2008. In this article we are going to take a look at both exchange traded and non-exchange traded Binary options.
Non-exchange traded Binary options
Non-exchange traded Binary options have been available over-the-counter for a long time. Traditionally non-exchange traded Binary options were considered an exotic instrument, due to the fact that there was no marketplace for the trading these options. Binary options were only generally found within complicated option contracts.
All of this began to change when in 2008, a number of online platforms started to offer a simplified version of exchange-traded options. It wasn’t long until the industry took off and it is estimated that there are over 100 different platforms offering this type of Binary options trading.
Non-exchange traded Binary options have come in for a lot of criticism, part of this criticism is due to the way that the platforms make their money. The platforms do not charge their users any fees or commissions, but rather make their money acting as the counterparty to client positions. Thus the odds are skewed in the platforms favour, for a trader to make a profit they will have to predict price movement correctly at least 55% of the time.
|Call/Put||Stake||Strike Price||Return (%)||Actual Close||Payout||P&L|
|Call (UP)||$100||100 =>||70||101||$170||$70|
|Put (Down)||$100||99 <=||70||101||$0||-$100|
For example our trader named John believes the USD/JPY will close above 100 at the end of the day. So John then buys a $100 Call/UP option from the platform with a fixed return of 70%. If the USD/JPY is above a hundred at the end of the day, John receives a total of $170. If the USD/JPY closes below 100, then our trader will receive nothing. It should be clear that in this case the odds are skewed in the providers favour. Assuming that each event was equally likely, a fair return for the option would have been 100%. In this situation John will have to be correct around 60% of the time to make profit, giving the provider a distinct edge.
Until recently non-exchange traded Binary options were largely unregulated, due the product falling into classificatory grey area. Many regulatory bodies were unsure whether the product was to be regulated as a form gaming or as a financial product as set out by MiFID. In May 2012 CySEC Cyprus’s regulator announced that they would begin to regulate the product as a financial instrument. This move made CySEC the first MiFID regulator to acknowledge Binary options as a financial product. In 2013 Malta’s Financial Services Authority followed suit taking over regulatory responsibility from the countries Lottery and Gaming commission. It remains to be seen whether other countries will start to regulate Binary options.
Many consider non-exchange traded Binary options to be a form of gambling, as the provider as has a distinct advantage over its clients. This sentiment was echoed by Gordon Pape in a strongly worded article on the subject of Binary options.
Exchange Traded Binary Options
Exchange traded Binary Options first came on the scene back in 2007 when the Options Clearing Corporation proposed a rule change to allow exchange traded Binary options. With the SEC then approving cash-or-nothing Binary options back in 2008, this really got the ball rolling and now it is possible to trade exchange traded Binary options through a number of regulated exchanges, including the CBOE, AMEX and now NADEX (by IG, one of our recommended ECN Brokers). US financial regulation prevents off exchange option trading and thus US citizens can only trade Binary options via a regulated US exchange.
|Call/Put||Contracts & Cost||Strike Price||Actual Close||Payout||Cost||P&L|
|Call (UP)||10 x $40||100 =>||101||$1000||$400||$600|
|Put (Down)||10 x $60||99 <=||101||$0||$600||-$600|
Exchange traded Binary options are slightly more complicated than their non-exchange traded cousins. Our trader again believes that the USD/JPY will close above 100 at the end of the day. He then goes and buys ten cash-or-nothing Call/UP contracts for $40 apiece, costing him a total of $400. Should the USD/JPY close above 100, he will receive a total of $1000, of which a total of $600 will be profit (10 x $100 contracts – $40 x 10 contracts). If the USD/JPY had not closed above 100, John would have lost a total of $400 ($40 x 10 contracts).
Those of you who followed our example trade above will have noticed that exchange traded binary options are priced differently. Instead of the option having a fixed percentage payout, each contract has a fixed payout with the price of the contract changing based on what traders are willing to pay. So if a standard $100 contract costs $40, the market believes the likelihood of that particular event to be around 40%. Unlike non-exchange binary options the exchange does act as a counterparty, but rather charges traders a commission for using the exchange.
This more complicated pricing model is the real strength of exchange traded Binary options, as it allows traders to use option pricing models to calculate whether an option is over or underpriced and thus trade accordingly. Various pricing models have been adapted to cater for exchange traded Binary Options, with it being possible to use well known pricing models to calculate theoretical value of a Binary options contract. For instance spreadsheets exist which allow traders to calculate the theoretical value of Binary option contracts using the infamous Black-Scholes Model. Thus exchange traded Binary options are a far superior opportunity.
Non-exchange traded binary options are skewed heavily in the providers favour and comparisons to fixed odds betting are not unjust, though it appears that a number of European regulators have decided such options are indeed a type of financial instrument. Exchange traded binary options have drawn much less attention, partly due to the fact that they are a more complicated instrument and partly due to the fact that they haven’t been as aggressively advertised. I would contend that exchange traded binary options are actually a far superior product, with plenty of potential for those interested in options trading.
Binary Options – Trading Risk and Intro
Can You Make Money With Binary Options?
Binary Options have become a very popular instrument online with numerous Binary Options platforms popping up everywhere. Many new traders are attracted to the high potential returns that these simple financial instruments offer, however many critical of Binary Options have noted that the odds appear to heavily stacked in favor of the provider. Today we are going to examine, whether the odds are unfairly stacked in favor of the Options providers.
When entering into a Binary Options contract you can either place put or call, this gives you two options. If one was to assume that the market was equally as likely to go either way the fair rate of return would be 100%. This situation would give neither party a distinct advantage and the party that came out the winner in the long run would simply be lucky. The trading of Binary Options differs from this hypothetical situation in two crucial respects:
- Binary Option providers typically give returns substantially lower than 100%.
- Markets tend to trend in a particular direction meaning that market isn’t equally likely to go either way.
Taking these two crucial differences into respect it becomes a lot more difficult to determine whether Binary Options as typically priced give a trader a fair shot at victory in the long run. Typically short term Binary Options offer a rate of return of around 70%, which means in order to have neutral expected value a trader would have to predict the market accurately around 58-60% of the time. This means that a trader would have to predict price movement with 58-60% accuracy just in order not to lose any money. If either outcome was just as likely it is clear that the trader would be getting a raw deal and we could expect him to eventually lose all his cash to Binary Options brokerage.
It does however appear that Binary Options could be profitable for those who could predict the market with a 60% degree of accuracy. It should be pointed out that not many trading systems can make sure term price predictions with that kind of degree of accuracy, many traditional trading systems are much less reliable but overcome their unreliability through proper risk management. For instance many Forex systems can be profitable while only correctly predicting market action 30% of the time. As a fixed-return option contract Binary Options don’t allow for this kind of risk management. If you were only able to predict price movement to a 30% degree of accuracy, you would be a significant loser trading Binary Options. In the MonteCarlo simulation I ran above it took 22 trades to bust the trader.
Binary Options do appear to have the potential to be profitable for those who are able to predict the markets with a very high degree of accuracy. Anyone who can reliably predict market price action with a degree of accuracy in excess of 60%, can expect to make a profit from trading Binary Options. However the number of people/systems which will be able to accurately determine price movement with such a degree of accuracy is likely to be extremely limited. I also believe that statistical variance could potentially lead to many people believing they have determined a highly accurate way to call the markets, before realizing that they have in fact just had a prolonged lucky run.
As Binary Options brokerages operate as a counter party to a trader and there is no way to hedge positions, it is unsurprising that the product is setup in such a way which makes it unlikely for individual traders to beat the provider in the long run. While I wouldn’t go as far as to deny that some individuals will be able to make money trading binary options, I would strongly advise that individuals take a serious look at whether they can really predict market price action with such a high degree of accuracy. If so, then you may just have a real shot at making money from Binary Options trading.
Binary Options Brokers or Is It Scam?
We cannot conclude that Binary Options per se are scam. Definitely not Nadex by IG which is the a binary exchange also regulated by the USA authorities, and possibility there are other good binary options brokers out there. The problem is that we have difficulties finding them. There are Forex brokers who also offer binary options on top, but most of them are not well-ranked in this website (for instance, Vantage FX and 24FX).
The only good companies that we can recommend that have passed out tests on this website are:
3. ZuluTrade (which is a social trading platform that will enable you to sign up to valid brokers)
We are on the lookout for additional reliable binary options websites and we shall be adding additional companies to this soon.
Binary Options History – How Did Trend Emerge?
Since their introduction back in 2008, Binary Options have risen quickly to prominence and are often marketed as the easiest way for the average joe to trade the financial markets. This rise of prominence is likely down to couple of different factors, firstly the Binary Options industry has fully embraced the affiliate marketing model and has offered those willing to promote their services handsome rewards. Secondly, Binary Options appeal to a new demographic who see traditional Forex or Share trading as too complex yet still want a way to make money from trading the financial markets. There is quite a lot of confusion surrounding Binary Options, this is in part due to the fact that there exist both Binary Options as offered by online platforms such as Banc De Binary and there are exchange traded versions offered by Nadex.
This article is going to focus on Binary Options as offered by online platforms such Banc De Binary, GTOptions and, 24 Options. Prior to the introduction of these platforms, Binary Options were seen as exotic instrument due to the fact there was no market for the trading of these over the counter instruments. It was common to find these Options embedded into an options contract and these Options were normally only purchased by extremely sophisticated buyers. It was not until 2008 that Binary Options became more firmly established in the public psyche, with a number of online web platforms offering the ability to trade Binary Options. The Binary Options as offered by these platforms were essentially just a simplified version of traditional exchange traded Binaries. The number of platforms operating quickly proliferated with it being estimated that by early 2012, there were over 90 of these such platforms operating. Part of the reason why the industry grew at such an astonishing rate was that the product was skewed heavily in the houses favor, with Binary Options being a very profitable instrument to offer.
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These kinds of online Binary Options have been widely criticized, as it became clear that the products were generally skewed heavily in favor of the house. Using Monte Carlo simulations it can be shown that in order to make a profit from Options which offer a 70% rate of return, one must accurately predict price movement with a 55% or greater degree of accuracy. Being able to predict price movement with a 55% degree of accuracy is actually much more difficult than it sounds. For instance many Forex systems only win around 30% of their trades but still manage to make significant profits by engaging in good risk management, essentially running with the profitable trades and cutting the losses short quickly. Binary Options however require the trader to be able to predict price movement with a high degree of accuracy and while I’m sure a limited number of individuals can predict price movement with such accuracy, I’m sure its beyond many traders.
Another problem regarding Options as offered by these online platform providers, is that for the majority of their history they have operated completely unregulated. Initially, a number of European financial regulators came out with statements saying that Binary Options were not under the remit of MiFID as they were strictly speaking not financial instruments. CySEC who initially released such a statement became the first European regulatory authority to regulate Binary Options. This led to White Label platform provider SpotOption to become the first company to be regulated on the basis of offering Binary Options. Soon after SafeCap Investments Ltd. who already held a full CySEC licence launched their TopOption platform. Shortly followed by Banc De Binary who gained CySEC regulation in early 2013. However many firms still operate completely unregulated often operating from offshore centers such as Belize and British Virgin Islands. This has left a sour taste in the mouths of some traders who have felt mistreated by some of the unregulated providers still operating in the market place. In early 2013 the European Commission ruled that Binary Options did fall under the definition of a financial instrument as laid out by MiFID, meaning that Binary Option providers looking to operate within the European Union would be required to gain financial regulation. However regulators have been slow to act and there are still plenty of Binary Option providers operating illegally within the European Union.
Steps are being made to combat unregulated brokerages, a court ruling in Italy recently forced Italian ISP’s to block a number of Binary Option websites who had been operating in Italy unregulated. Previously in 2012 a number of Binary Option brokerages were blocked by Turkish ISP’s on the basis of alleged criminal activities being undertaken by the firms. It thus seems that something is finally being done about rogue operators within the Binary Options world, though questions still remain regarding whether is product worth using with many feeling Binary Options are inferior to both Contracts for Difference and financial spread bets.
Comparing Gambling to Binary Options
Since they emerged on the trading scene back in 2008, over-the-counter Binary Options in the form offered by well known brands such as 24Options and Banc De Binary have received a lot of attention. It wasn’t quick until the negative press regarding these off exchange Binary Options providers began to mount up, with a number of rogue operators taking advantage of customers who had signed up to trade. Binary Options also received a significant amount of criticism as a product with many stating that these so called Options were no more than fixed odd financial bets in disguise. This criticism has been widespread with articles in major publications comparing Binary Options to gambling.
Unlike with other forms of financial trading, Binary Option brokers can only turn a profit if the majority of those betting on a particular market lose. Binary Option brokers price the Options using a formula which monitors the amount of money placed on a particular market and calculates odds which should see the brokerage turn a profit regardless of the outcome. This model is very similar to the one used by traditional bookmakers when they take bets on sports. When taking bets on a football game a bookmaker, will initially price the market in way in which they profit regardless of the outcome of the game. If a lot of money is placed on one particular outcome the bookmaker adjusts the odds to partially cover their risk. The business model used by Binary Option brokers is remarkably similar to the one used by traditional bookmakers and it is no surprise that Binary Options are often considered a form of gambling.
Another reason why Binary Options are often considered a form of gambling is that the company offering these options, always prices the options in a way which gives them a distinct advantage. Binary Option providers tend to offer returns of around 75%, which gives them a significant edge over their customers. This means that customers have to correctly guess which way the market is going to move around 65% of the time in order to just break even. While I’m sure that there are some people that can overcome this significant disadvantage, the majority of people who try their at hand at Binary Options are going to come out losers.
One other reason is commonly cited to why Binary Options should be considered a form of gambling. The majority of Binary brokers primarily offer very short term Options, with many trades lasting no more than a minute. Some have said that this makes even more difficult for those trading Binary Options as it can be extremely difficult to predict such short term price movements, this combined with the fact that the Binary Option broker having such a significant edge means it’s unlikely for those trading Binaries to ever turn a profit.
Binary Options: Is It Trading?
Some insist that Binary Options can be differentiated from gambling and should be considered a form of financial trading. For one it is the opinion of the European Commission that Binary Options are in-fact a financial instrument as defined in the Markets in Financial Instruments Directive. Despite the opinion the European commission, only two European countries have classified Binary Options as being a financial instrument. It is true that the decision by Cyprus and Malta to regulate the Binary industry did give the product more legitimacy in the eyes of many.
Some also believe that Binary Options should not be considered a form of gambling, as it is possible for skilled Binary traders to beat brokers despite the latter’s significant statistical advantage. There also people that prey on the grand bonuses offered by Binary Options brokers, similarly to casino bonus hunters who abuse the large welcome bonus some casinos offer. It certainly seems that some have been able to profit from Binary Options, but industry statistics suggests that average customer loses around $1,200 before giving up Binary trading. Which strongly suggests that the average Binary trader comes out a significant loser, which isn’t surprising considering the advantage which brokers posses.
Binary Option brokers operate in a way similar to bookmakers, making profit only when the majority of their customers lose money. This combined with the fact that Binary Option providers have a significant edge over their customers has led many to compare Binary trading with gambling. Despite this some insist that Binary Options are not a form of gambling, but are instead a legitimate form of financial trading, however these arguments aren’t particular convincing. It does certainly seem that Binary Options are comparable to gambling in a significant number of ways and it is for this reason they have received a lot of criticism as trading instrument.
Comparing Binary Options and Forex
Since their launch in 2008 off-exchange traded Binary options have grown massively in popularity, while the take up of their exchanged traded counterparts has been much slower. The phenomenal growth of the Binary industry has been fuelled by aggressive marketing focusing on the ease of Binary Options trading and how traders can make impressive returns within the space of a minute. Some have suggested that Binary options may slowly erode the dominance of Spot Forex trading.
In this article we are going to take a look at some of the pros and cons of both Binary Options and Spot Forex as financial instruments.
- Easy to understand: Binary Options are very easy to trade. Traders simply find the instrument they want to trade and then make a decision regarding whether the price of the instrument is going to rise or fall over the selected time period.
- High Payouts: Part of the recent growth of the Binary industry is that brokers aggressively advertise impressive returns often in excess of 70%+. Those trading Binary Options can potentially make a 70% return.
- Poorly regulated industry: Currently only Malta and Cyprus regulate Binary Options as financial instruments. While this is a start in the right direction many feel that Binary Options aren’t really a financial instrument and should be categorised as a form gambling.
- Odds Stacked In the houses favour: While a 70%+ return on an short term option may sound great when you drill down into it, the firm offering the option has the odds stacked in its favour. Traders have to on average predict price movements with 60%+ degree of accuracy to simply breakeven. Anyone with trading experience will tell you that this is extremely difficult.
- Firms Profit off client loses: The interests of the firm aren’t aligned with the customer. As there is no market for the trading of these options firms can’t hedge positions and only profit when the client loses. This is not the case with Forex brokers that do not operate dealing desks, meaning that interest of the client and brokerage are perfectly aligned.
- Heavily Regulated Environment: While there are still numerous brokerages that operate completely unregulated in many jurisdictions Spot Forex is heavily regulated. In European Union Forex falls under the EU’s MiFID legislation which ensures a minimum standard of financial regulation. Those who do their research will be able to choose between a range of highly regulated and reputable brokerages.
- Client and Brokerage Interests Better Aligned: True ECN and STP Brokerages profit from volume placed through the brokerage rather than from clients losing money. This means STP and ECN brokerages ultimately want clients to profit to ensure they continue to receive trading volume. Even Market Makers can profit from successful clients if they do everything correctly from a risk management and hedging point of view.
- Leverage: Traders can take advantage of significant amounts of leverage. This allows traders to take on much bigger positions than they would otherwise be able too. This can help traders maximise potential profits though leverage can also work against a trader.
- Complex compared to Binary Options: Spot Forex trading is much more complicated and those new to financial trading will face a steep learning curve. Pips, Lots and leverage will all be new to those who don’t have prior knowledge of the Foreign exchange market. This is a significant barrier to entry to many who want to simply make money from financial markets without taking the time to learn the ins and outs of trading.
Many consider Binary Options as a poor product with some likening Binary trading to gambling. This comparison is not unreasonable with Binary Option firms profiting from client losses in a similar way to how bookmakers profit from their clients. This creates a clear conflict of interest as it is in the brokerages interest for clients to lose, combined with a lax regulatory environment has led to the industry gaining a bad reputation. In my opinion, Spot Forex is a superior product and those who are interested in trading financial markets should certainly look into Forex as one option. Of course all forms of financial trading involve significant risk and individuals seek independent advice to determine whether trading is for them.
Binary Options And Social Trading: Potential Problems
Ever since the first FX social trading products were launched back in 2008, the growth of social trading has been extraordinary with a large number of products being launched to compete with industry pioneers such as eToro and ZuluTrade. 2008 was also the year which saw the launch of non-exchange traded Binary Options, a controversial but highly popular new financial product. The Binary Option industry has come a long way since 2008, with the product now being available via regulated providers in both Malta and Cyprus. It is only recently, in 2014 that the Binary Options industry has started to look towards offering social trading products for those trading these non-exchange traded Binary Options. Whether Binary Social Trading will gain anywhere near the same level of popularity remains to be seen and their appears to a number of factors which preclude Binary Options being paired up successfully with social trading.
While Binary Options are considered by many to be a financial product (including CySEC and the MSFA) they share a lot in common with fixed odd betting. Traders are given two choices, whether an asset will rise in value or depreciate over a certain time frame. Traders then choose an amount to stake on their decision with the opportunity to receive a fixed return should they correctly guess the price direction of the relevant asset. This essentially means that the Binary Option brokerage loses should the trader win, and only profit if a trader loses money. Overall, Binary brokers tend to be wildly profitable as the majority speculating using the instrument lose out and it’s possible to change the odds to make more difficult for those who were successful to turn a profit in the long run.
Social trading sees traders automatically copy the moves of the most successful traders, the idea being that even those without the necessary skills and ability will be able to profit from the financial markets. It often doesn’t work out like this with many users having a negative experience with social trading. But many of the best signal providers on the larger social trading networks have acquired hundreds of live followers who automatically copy their trades. This doesn’t necessarily pose a problem when it comes to FX, as brokerages often turn a profit by widening the spread or charging commission which allows them to remain profitable even if their traders make money. Binary Option providers however depend on traders losing in order to make a profit, so a large number of traders making the same successful trades presents a significant risk management problem.
It is not immediately apparent how Binary Options providers can deal with this risk management problem without dramatically slashing the odds when a large number of traders start taking up similar positions. This approach would simply significantly reduce the appeal of Binary Options whose appeal lies mainly in the high returns aggressively advertised to prospective traders.
Despite these significant problems a number of social trading products have been developed which aim to bring social/copy trading to the world of Binary Options.
Social/Copy Trading Products for Binary Options
Launched in 2008, ZuluTrade has become one of the leading copy trading venues online with over 30,000 signal providers offering their signals to those wishing to automatically trade the FX markets. In 2014, ZuluTrade announced an exclusive partnership with SpotOption the leading provider of White Label Binary Option solutions. This will allow ZuluTrade users to copy the trades of leading Binary signal providers and have these trades executed with any SpotOption powered Binary Broker which decides to integrate with the ZuluTrade platform. At the time of writing, 12 Binary Options providers were offering integration with the ZuluTrade platform, representing a small percentage of providers using the SpotOption White Label Solution. ForexMagnates covered the launch of the product, and commentators raised a number of questions regarding how risk would be adequately managed in order to prevent large broker loses. There has been no official answer regarding this particular question, which means it still remains to be seen how option providers will manage their risks in regards to social trading.
Almost immediately a number of successful Binary Option Signal Providers popped up on ZuluTrade offering signals for those looking to engage in Binary copy trading. At the time of writing it appeared that the vast majority of signal providers were providing signals using demo accounts and the top ranked signal provider on ZuluTrade had 0 Live Followers. It remains to be seen how successful the Binary Options product from ZuluTrade will be both with brokers and traders alike.
Trade4.me, is a Binary Options Social Trading network which was in public BETA at the time of writing. The network allows traders to share their Binary signals with other traders who then copy the trades into their own accounts at a number of supported brokerages. Again the majority of supported brokerages appear to SpotOption, though from the forums it seems that the company is attempting to add a number of non SpotOption platforms to the network. At the time of writing the network had under 2,000 users, with some of the better traders on the leader board posting reasonable returns over a relatively long term period. It is not clear how the network is monetized though it appears that Trade4.me is remunerated based on business brought to the supported Binary Option brokers. Again the, Trade4.me product is still in its infancy and it’s hard to draw any solid conclusions at this time.
Binary Options Social/Copy trading is very much in it’s infancy, and it is still not clear how Binary Option brokerages would deal with the risks involved in having a huge number of traders enter into the similar positions should any Signal Providers gain a significant amount of notoriety. It also remains to seen whether there is significant demand from traders for such products.