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In the world of financial markets and derivatives, there are many different ways of investing and trading to (hopefully) make a profit. From CFDs to forex trading and stock trading to bitcoin, there’s no shortage of opportunity. Binary options, unfortunately, have proven to be a rather persistent trap for would-be traders and a snare for many beginners looking for a simple, seemingly straightforward introduction to the financial world.

Understanding binary options

Understanding binary options

Binary options allow traders to win or lose a fixed amount based on the movement of any financial instrument, underlying asset or market for a certain period of time. As its name suggests, the option provides two ‘binary’ alternatives for the movement of a particular financial instrument, market or asset. Traders trade based on whether they think that that movement will be upwards or downwards, thus placing their trade according. Not to spoil the rest of the article, but by “think” we actually mean guess.

The significant appeal to understand about binary options is that it has three clear, definite parts to it:

  • A definite expiration date;
  • A defined time period; and
  • A clear strike price.

Binary options seem so appealing because they offer traders a cap in terms of the risk to which they financially expose themselves. Sure, even enthusiasts will admit that they also lock traders tino a capped profit but for many the appeal of having a limited risk exposure seems too good to be true. And it just might be.

The significant feature of the binary option is the fixed return offered. When the option expires, the trader will either receive or lose the fixed return regardless of how much movement there was. It’s entirely based on the binary result, not the degree to which the outcome was correct or incorrect. Thus, the quantitative risk and reward is known.

The expiration date or time is the point at which the trade ends and the price at that point determines whether the trade is won or lost. While hypothetically the expiration times can vary in lengths in anything from a minute to a full year, the reality is that most people enticed into trading in binary options are grabbed by the supposed promise of quick returns. Hence, most binary options tend to be very short term gambles.

Trading on fluctuations and making money

So, what are you supposedly doing when you trade with binary options? You’re betting on the fluctuations of the market of a brief but specific space of time.

They can be traded on any underlying asset including:

  • Major stock market indices, such as the DOW 30, Nasdaq 100, or S&P 500
  • Global indices such as the UK, Japanese or a European market.
  • Foreign currency pairs in the forex market
  • The price of commodities, from gold to crude oil, and from copper to corn.

To make money on a binary option one of two things needs to happen:

If a call is made, the price of the stock, commodity or currency pair (in forex trading) needs to be above the strike price at the expiration date (or time).

If a put is made, the price needs to be below the strike price at the expiration time.

What makes binary options such a bad idea?

At this point you might be wondering what makes binary options such a bad idea? It seems simple enough and not too bad, right?

Well, you might be right if you consider binary option trading the same way you consider betting on red at a roulette table in a casino. Afterall, that’s what binary options basically comes down to: gambling.

The gamble

Extremely short bets on market fluctuations are more likely to be a complete and utter guess than based on any knowledge. After all, if you’re placing a zero-sum $100 bet on where a specific stock will go in the next minute or 10 minutes, you’re certainly not making an informed decision based on well considered information. It is, for lack of a better word, a gamble.

But if the risk is limited and potential losses are capped, why is it so bad?

Much like visiting the casino, binary options tap into the same gambler’s psychology. It’s addictive to make a simple yes/no or up/down bet and see whether you “win”. Tendencies to adopt a Gambler’s Fallacy mentality and continue trading in binary options in the hope that your losing streak is bound to break at some point will end up in you just losing more money over time.

Lack of regulation

The lack of sufficient regulation and oversight over binary option trading makes the entire endeavour a lot riskier than other forms of trading. Scams and fraudulent behaviour have become more associated with binary options than other trading and if something does go wrong with your trading, there is no overarching organisation to which you can turn. For example, if there is discrepancy in your trade, there is no external body that regulates binary trading to settle the dispute. Even brokers, by not relying on external sources for quotes in trading, can be vulnerable to malpractice.

For this reason, binary options is a restricted form of trading in the U.S.A. If you’re a foreign binary option broker you must be registered with an American financial regulatory organisation in order to solicit traders who live in America.

Inside the U.S, the Chicago Board Options Exchange and North America Derivatives Exchange (NADEX) have both set up exchanges to facilitate those who wish to trade binaries in the U.S. Not only was this only done in 2008, but it’s also been established with heavy regulations in an attempt to offer increased protection for traders and investors. While their regulation is better than none, it’s still a far cry from other forms of financial trading and doesn’t offer much by way of security for non-U.S. traders. Financial regulatory authorities in the U.S. have warned traders to be aware of companies that offer platforms for trading in binary options.

Online scams are also a huge risk factor. Even if you’re sold on the theoretical idea of binary options, many of the supposed online trading platforms are really scammers masquerading as legitimate brokers. Once the funds for ‘trading’ are transferred there are no trades actually placed, binary option or otherwise, and the scammers simply pocket your money and move on to the next starry-eyed, unsuspecting victim.

High risk and low reward with traders

While your first and instinctive reaction to binary options may have been, “Well, that’s not too bad because there’s only so much I can lose with capped losses” and your initial reaction to our comparison with gambling might elicit a response like, “Well, I’m not a gambler so I won’t make that mistaken”, allow us to break down some numbers for you.

First, you need to realise that to make serious money you need to execute a series of successful binary trades. If you’re not risking a huge amount, you’re not going to make a huge amount. But how much do you need to trade?

Most online web traders for binary options set up their platforms in such a way where the house (to extend the casino analogy) always wins. For example, let’s say they will pay you $75 for every successful trade of $100 you make. But if your $100 trade is not successful they only give you back $10. Now, you make 1000 individual trades. If you win 50/50, you’ll win 500 trades and pocket $37,500. But you’ll also lose $45,000.

See the problem? You don’t break even even if you win exactly half of your bets. You need to win over half of all your trades just to come out with the same amount of money as you went in with. Now, consider the odds on winning enough trades to actually make some money on binary options!

That’s not smart investing. That’s really not investing at all.

Lots of volatility with little information

Not only is binary option trading capped in terms of financial gain but it’s more volatile than other types of trading because the options are derivative-based. Combine that with the fact that binary option brokers do not have the same trading tools as traders in other markets and it’s increasingly unlikely that any binary option trade will reflect an accurate, informed or educated choice.

If you think that your odds are higher than 50/50 because you have reason to suspect that the short term volatility of a market is predictable, we strongly suggest you revisit the fundamentals of smart, successful trading. You don’t have to take just our word for it, though: ASIC themselves have warned that the vast majority of binary traders lose money. (Not to mention that over a third of all market-related complaints had to do with binary trading.)

A last word on binary options

Before embarking on any trading or investment scheme, it’s vital you ensure you have a complete understanding of the market, the trading structure, the risks, rewards, advantages and disadvantages. If you’re still considering binary trading, we can’t stress enough how important it is that you invest the time and effort into understanding what makes this form of financial trading so unsuitable for investing.

Fortunately, you don’t have to do this alone. The team at Global Prime are always here for a friendly, no-obligation chat about all things trading and financial markets and happy to further discuss better alternatives for beginner traders that offer more informed investment strategies than binary options.