Betting has always been an attractive concept. Consumers bet on sports, the turn of a wheel or dice, card games, and a wide range of other arenas.
The gambling industry is massive and so are the profits it creates, so it should come as no surprise that companies that make their money from bets are constantly looking to offer new ways to play.
For years, people looked for ways to turn the financial markets into a game of chance, and it makes sense. After all, many already associated the concept of investing with gambling. After some thought and innovation, binary options trading was born as a way to bet on the fast-paced whims of the stock market with a win-or-lose outcome.
While binary options have become popular among short-term traders, they are not a good fit for most investors as a core strategy for wealth building or establishing your retirement account. The extreme risk involved makes it best for most investors to avoid them.
What Are Binary Options?
Binary options are a financial product known as a derivative, meaning their value is derived from price movements in the underlying assets they’re based upon, instead of bestowing ownership of those assets.
The term “binary” points to the all-or-nothing way these investment vehicles work. When trading binary options, there are only two possible outcomes: you either earn a fixed return on your investment, or you lose your investment altogether.
Because you’re not buying the underlying asset when trading these financial instruments, you won’t take part in gains or losses on a percentage basis as you would with traditional investments in stocks, currencies, or commodities. Instead, you’ll be making bets on the short-term ebbs and flows of the price of the underlying asset over a predetermined period of time.
There are a few terms to consider when trading these assets:
The payout associated with binary options is the amount of money you stand to make if your prediction is correct, meaning the trade ends “in the money.” Of course, if the trade ends out of the money, meaning your prediction was incorrect, you’ll lose your entire principal investment in the trade.
A call option is the trade you’ll make when you believe the value of the underlying asset is going to increase during the trade. The best way to remember this is to think of the expression “to call someone up” — when you buy a call option, you believe that the price of the underlying asset will move in the upward direction.
A put option is the trade you’ll make if you believe the value of the asset you’re trading is going to fall from its current price. The best way to remember this is to think of the expression “put that down” — when you buy a put option, you’re hoping for downward price movement.
The strike price is the point at which a trade is considered in the money. The strike price on a binary option will either be higher (on call options), or lower (on put options) than the asset’s current price.
Once the price of the underlying asset falls below (for put options) or climbs above (for call options) the strike price, the option is in the money and the trade becomes profitable. If the asset does not move above or below the strike price through the course of the trade, the option will expire with absolutely no value, taking your principal investment down the drain with it.
Expiry or Expiration Date
These trades happen over the course of a predetermined time frame, with the end marked by an expiry date, which acts as the expiration date on the trade. For the trade to be profitable, the asset’s value must rise above or below the strike price prior to the expiry date.
Binary options contracts generally last for minutes or hours, making these trades some of the shortest-term trades on the market today.
Pro tip: If you’re looking to start trading options, make sure you sign up for the Motley Fool Options community. Not only will you receive options trading recommendations from the experts at Motley Fool, but you will also be joining a community of like-minded investors.
U.S. vs. Foreign Binary Options
While the above are the basics for most binary options, those traded in the United States differ from those traded in foreign countries. Before getting involved in trading these financial assets, it’s important that you understand the key differences between the two and make an educated decision as to which you’ll be better off using.
U.S. Binary Options
Binary options trading was available through European brokers long before it became available in the United States. In fact, binary options weren’t available here until 2008, when the Securities and Exchange Commission (SEC) finally gave the green light.
Today, binary options are traded commonly on U.S. exchanges and regulated by the Commodity Futures Trading Commission, or CFTC. However, there are a few significant differences between the assets available in the U.S. and those overseas.
If you’re interested in trading binary options on individual stocks, you’ll have to sign up with an overseas broker. In the U.S., you’ll be able to take part in binary options surrounding forex trading, commodities, stock indexes, and cryptocurrencies like Bitcoin.
In the U.S., binary options are used to place wagers on currency pairs and other financial instruments, like just about everywhere else. However, traders also use them to place wagers on economic events like the direction of the Federal Reserve Bank’s fed funds rate, the number of jobless claims in the U.S. in a week, or growth in payroll numbers across the country.
Investor vs. Investor
When trading these financial contracts with European brokers, you’re actually betting against the broker, an act that’s illegal in the U.S. Here, contracts are made with investors on both sides rather than pitting the broker against the investor and creating a conflict of interest.
With European brokers, prices on binary options are set by the brokers themselves, who use algorithms and detailed research to give themselves the upper hand. In the U.S., the price of binary options is set through an auction price based on the prices investors are willing to buy and sell the options for. Investors willing to buy at higher prices and sell at lower prices have the priority, as is the case in the stock market.
The vast majority of binary options in the U.S. are traded on the North American Derivatives Exchange (NADEX).
Contracts traded on the exchange all have a value of $100, meaning that if the strike price is achieved, the investor who purchased the binary option will receive $100. If the majority of investors believe the strike price will be achieved, the strike price will climb close to $100.
On the other hand, if investors don’t expect the strike price to be achieved, the price of the binary option will fall away from $100, offering a larger return for those willing to take the risk.
Popular U.S. Binary Options Trading Platforms
Although there are hundreds, if not thousands, of binary options brokers online today, there are only a handful to trade with in the United States:
- NADEX. NADEX is where the majority of binary options are traded in the United States. This is largely because the exchange caters to the individual investor.
- Cantor Exchange. The Cantor Exchange makes trading available through multiple brokers that use it to gain a presence in the U.S. market. On the exchange, binary options are all valued at $1 and sold in blocks of up to 1,000 contracts.
Foreign Binary Options
The vast majority of foreign binary options brokers are located in the European Union. Like all brokers in the industry, they offer investors the ability to place wagers on whether an underlying asset will cross a specific strike price in a predetermined period of time, ranging from minutes to hours.
While there are plenty of similarities between U.S. and European binary options, there are also significant differences:
Assets Available to Trade
As is the case in the U.S., you’ll find opportunities to trade currency pairs, commodities, and more. However, European brokers are also able to offer contracts on single stocks, making them appealing to traders looking to place wagers on the ebbs and flows of their favorite publicly traded companies.
Odds Are Against You
While you may think you know the companies you bet on in foreign binary markets well, the odds are stacked against you in a big way when trading with European brokerages. With these brokers, you’re not placing a wager against another investor; instead, you’re placing a wager against the broker themselves.
It’s literally like going to the casino and playing games that you can win, but the house is more than likely going to beat you. These brokers lure traders in by offering no fees and the promise of massive returns, but if everyone was making those massive gains, the brokers offering the options would be out of business.
Unlike options traded on the NADEX or Cantor Exchanges, contracts through European brokers don’t all have the same payout amount. Instead, the payout on the option is set by the broker based on what they believe the likelihood of the option passing its strike price to be.
When the brokers see a trade as a sure bet, they offer the promise of significant returns to get more traders to take part in the high-risk trade, with the opposite being true on trades that are likely to end in the money.
Popular Foreign Binary Options Trading Platforms
Although foreign brokers make their money betting against their customers, you can beat the system with a detailed understanding of technical analysis and a little luck. Few binary options traders in these markets are successful, but those who are make massive amounts of money; so for some, taking the risk to trade with foreign brokers is appealing.
If you do decide to take the risk and test your technical analysis capabilities, it’s best to work with a trusted broker. Some of the most popular platforms outside of the United States are offered by:
- Pocket Option. Pocket Option offers a 50% deposit bonus for new traders. The company also offers social trading, instant withdrawals, and a maximum profit of 96%. There are more than 100 assets available to trade with minimum trades at just $1.
- BinaryCent. BinaryCent is a good fit for traders who want to trade forex and contract-for-difference CFD binary options. The broker offers a deposit bonus of up to 100% depending on the size of your first deposit and features 95% payouts and minimum trades of just $0.10.
- RaceOption. RaceOption is a platform designed for beginners and packed with educational materials. The max return is 90%, and first deposit bonuses range from 20% to 100% depending on the size of the deposit.
- IQ Option. Many traders use IQ Option because of its robust list of instruments to trade. It offers access to more than 250 different assets. The broker also offers minimum deposits of just $10 and maximum payouts of 95%.
- ExpertOption. ExpertOption offers access to more than 100 assets including stocks, commodities, cryptocurrencies, and forex. Touted as one of the best platforms for mobile traders, the broker offers access with a minimum deposit of just $10 and a maximum profit of up to 95%.
Beware of Scams
Binary options are an exciting concept. After all, who doesn’t want to make a quick 90% or 95% return on their investments?
Unfortunately, the risks associated with short time horizons and brokers betting against their customers are often the least of your concerns as a newcomer to binary options trading.
Anywhere there’s a ton of money to be made and unsuspecting victims to take advantage of, there will be con-artists planning their next scam. The binary options industry is no different.
In fact, scams in the industry are so common that in 2017, regulators in Israel as well as the Financial Conduct Authority in the United Kingdom banned binary options trading altogether in their respective regions, followed by a number of other countries and jurisdictions including Belgium, Canada, Germany, and several others.
In 2018, the EU banned binary options trading as well. While that ban exists, the Cyprus Securities and Exchange Commission (CySEC) continues to register these brokers to serve customers in Cyprus—an EU member—and around the world.
As a result, if you decide to trade these financial vehicles, it’s important that you do so with caution, keeping an eye out for scams and doing in-depth research on brokers before deciding to sign up. Wise investors should use an SEC-registered broker for all transactions.
Popular Binary Options Trading Strategies
The vast majority of binary options trading strategies require a detailed understanding of technical analysis and access to various technical indicators and charting capabilities. Some of the most commonly used strategies include:
- In the Money. The in-the-money trading strategy is best used when markets are trading flat. The idea is to buy binary options that are already in the money under the idea that markets wont make any sudden, dramatic moves. As long as prices don’t fall below or rise above the strike price, staying in the money, you’ll earn a return.
- Trading the Trends. Trading the trends is one of the most popular strategies followed by traders, professionals, and newcomers alike. The strategy involves finding assets that are following high momentum trends in one direction or another and placing trades in the direction of those trends.
- Trading the News. News has the potential to shift investor opinions surrounding financial assets, which ultimately leads to price movement. Trading the news involves using fundamental analysis to find market-moving news (fundamental), then using technical analysis to decide the best time to enter trades.
- Trading Candlestick Formations. Most financial charts are made up of lines that show the direction of a financial asset. Candlestick charts provide more information, showing you low and high prices experienced through periods of time, more clearly outlining support and resistance. Many traders look for formations in candlestick charts to determine when it’s best to enter trades.
Risks Associated with Binary Options
Before trading or investing in any financial instrument, it’s important to consider the risks associated with that decision. When it comes to binary options trading, the process is a highly speculative one that involves significant risk. Consider these most pressing risks before getting involved.
1. Short-Term Trading
When making predictions as to where the price of a financial asset is headed, you’re essentially making an attempt to predict the future. Since nobody has a crystal ball that allows them to clearly see the future, this is done through analysis of the asset and its price movement.
However, short-term predictions have a much lower likelihood of being accurate.
Think of it this way, if you said there would be a hurricane forming in the Atlantic tomorrow, chances are that you’d be incorrect. However, if you predicted that a hurricane would form in the Atlantic over the next year, you’d likely be correct, as several hurricanes form in the Atlantic in an average year.
Because binary options come with such a short time horizon, the probability of predictions being correct shrinks immensely.
Those who trade these assets tend to look for highly volatile assets, meaning that the price of the asset moves quickly in one direction or another. Unfortunately, this is one of the worst things traders can do, as highly volatile assets make predictions more difficult than assets that move at a slow and steady pace.
When trading most financial assets, you’ll take part in the percentage gains or losses experienced by that asset. When trading binary options, you don’t take part in any percentage gains. Instead, you’re getting involved in an all-or-nothing trade, one where you have the potential to lose 100% of your initial investment in a matter of minutes.
4. Difficulty Withdrawing Funds
Some brokers, even some reputable ones, require an account to be active before the trader can withdraw his funds. These hurdles make accessing your own money more difficult.
5. Lack of Regulatory Oversight
Regulation is important in any financial market, and the binary options market is lacking it in a serious way.
While brokers in the United States are regulated by the CFTC, foreign brokers are often completely unregulated, and most that are are regulated by CySEC — a regulatory body that’s nowhere near as strict as U.S. regulators like the CFTC, SEC, or the Financial Industry Regulatory Authority (FINRA).
Even in the United States, where regulations in financial industries are stringent, fraud happens. However, when brokers are unregulated or underregulated, the probability of fraud only increases.
Binary Options Trade Examples
As mentioned above, the binary options industries in the United States and around the world are different. Here are examples of each:
U.S. Trade Example
When trading binary options in the United States, there are two traders involved: the person buying the option, and the person selling it. Here’s how it works:
Trader A believes the price of gold will climb from the current price of $1,880 per ounce to above $1,900, while Trader B doesn’t believe that to be the case. Trader B agrees to sell a binary option with a strike price of $1,900 to Trader A for $75. If the price of gold moves above the $1,900 strike price, Trader B will have to pay Trader A a $100 payout.
Here are the two ways this could end:
- In the Money. If the price of gold climbs above $1,900, Trader B will have to pay Trader A the $100 payout on the trade, giving Trader A a $25 profit in the process.
- Out of the Money. If the price of gold doesn’t reach $1,900 prior to the expiration date of the trade, the option will close out of the money, meaning that Trader B will keep the $75 Trader A paid for the contract as profit.
Foreign Trade Example
When trading binary options with foreign brokers, there is only one trader involved, and that trader makes bets against the broker.
Returning to the example above, say the trader believes the price of gold will climb above $1,900 and is willing to risk $50 on the bet. Using an algorithm, the broker figures out the probability of gold rising to more than $1,900 per ounce, and because the price is already relatively close, it sets a 10% profit potential on the trade.
Here are the two ways this could end:
- In the Money. The price of gold surpasses the strike price of $1,900 per ounce, causing the trade to end in the money. In this case, the investor would receive the $50 principal investment back plus 10%, for a total of $55, or a $5 profit.
- Out of the Money. The price of gold doesn’t surpass $1,900 by the time the trade expires, causing the trade to end out of the money. In this case, the broker would keep the initial investment of $50, meaning that the trader loses 100% of their investment.
Who Should Consider Trading Binary Options?
Binary options certainly aren’t for everyone. Traders who would be a good fit for this type of vehicle include:
- Experienced Traders. Those who trade binary options should have extensive knowledge of the underlying assets they trade and what causes them to move. While research is a great place to start, the only way to truly get the knowledge you need to be successful is through significant experience. This is not a trading vehicle for beginners.
- Technical Analysis Experts. Technical analysis is the process of looking for patterns in the asset’s chart to determine future price movement. Those who trade binary options profitably are generally technical analysis experts with a wide range of indicators and charting capabilities at their disposal.
- Traders With a Large Appetite for Risk. Binary options are a high-risk asset, and trading these assets comes with a significantly higher potential for loss than trading other assets like stocks and bonds. As a result, only those with a healthy appetite for risk should consider them.
- Traders With Money to Lose. Trading binary options is a risky concept and can result in significant losses. Only excess funds or a bit of “mad money” should be used to attempt trading these assets.
The truth is that 99% of market participants should avoid binary options. According to WOW Online, only between 10% and 30% of people who trade binary options ever make money doing so.
Those who do make money in binary options generally have several years, if not decades, of experience trading in financial markets, combined with a detailed understanding of what causes prices to move and the technical indicators that make technical analysis possible.
Nonetheless, if you decide to try your hand at trading these derivatives, it’s important to do your research with each trade. Moreover, no more than 5% of your entire portfolio’s value should ever be risked in binary options trades, because a bad prediction leads to the loss of your whole principal investment.