In early 2004, 32-year-old Englishman Ashley Revell sold everything he owned – furniture, clothes, car, golf clubs, and his old cricket bat – to raise almost £76,840, or the equivalent of approximately $140,617 in U.S. currency (per the average 2004 exchange rate). On April 11, 2004, Revell walked up to a Las Vegas roulette table and placed his entire fortune on the color red.
Roulette, named after the French word meaning “little wheel,” is played with a small ball and a wooden wheel with 38 slots or pockets for the ball to rest in. In American roulette, 18 slots are red with odd numbers, and 18 slots are black with even numbers. Also, two slots are green and marked as “0” and “00.” The game begins when the dealer (croupier) spins the wheel in one direction, then spins the ball in the opposite direction. Winning or losing is based upon the slot in which the ball finally comes to rest.
The odds of picking the correct color are 38 to 18, or 47.4%. In other words, Revell’s chance of winning was less than the odds or a single coin flip. Fortunately for him, the call came to rest on a red pocket. Revell won £153,680, doubling his money in less than 20 seconds.
According to the Binary Option Brokers Association, online gaming companies had searched for years to find a product that was “easy to trade, highly rewarding, and tied to financial markets.” The solution: Binary options – also known as “all or nothing” or “high-low” options – which give investors an opportunity to play the market similar to sports betting and roulette.
Easy to understand, the more popular binary options provide almost instantaneous feedback and gratification. Binary options do not require ownership of the underlying asset, being simply wagers about price direction within a set time. According to CNBC, binary options have become increasingly popular with U.S. investors, despite critics who compare the option to “buying a lottery ticket.”
The options, available from European brokers for years, gained SEC approval in 2008. Binary options were first traded in the U.S. on the American Stock Exchange and subsequently by the Chicago Board of Options Exchange (CBOE). Today, binary options in the U.S. are primarily traded on the North American Derivatives Exchange (Nadex) or the Cantor Exchange (CX), each regulated by the Commodity Futures Trading Commission (CFTC).
According to Nadex, 5,000 contracts are traded daily on the exchange, and the popularity of binary trading is growing – volume on Nadex increased 64% in 2016, as the ability to trade minute-to-minute price movements in currencies, commodities, stock indexes, economic events, or the price of Bitcoin is irresistible to some people. Though a wide range of assets are tradeable on regulated exchanges in the U.S., binary options on individual securities are only available with foreign brokers.
Binary options are considered “exotic options” since they differ significantly from the highly regulated standardized call and put options traded on an exchange such as the CBOE, NASDAQ Options Market, or the NYSE Amex Market. Binary options are traded on exchanges and over-the-counter (OTC) around the world, including the United States. A binary option can be viewed as a wager on the direction of the market (or another underlying asset) within predetermined period of time.
Potential traders should understand the following aspects of binary options before making a trade:
1. Underlying Asset and Available Assets to Trade
The term “underlying asset” refers to the financial asset for which binary options are available. In the U.S., the underlying assets include:
- 4 different U.S. and foreign stock indices
- 7 commodities, including gold, crude oil, and corn
- 10 Forex currency options and spreads, such as the British pound to the U.S. dollar or the euro to the Japanese yen
- Bitcoin (traders can buy binary options on the price of bitcoin without purchasing actual bitcoin).
- Economic events such as the Fed Funds Rate, the Weekly Jobless Claims, and the Nonfarm Payroll. For example, a trader could buy a binary option on whether the Jobless Claims will rise or fall in increments of 2,000, 5,000, 10,000, or 20,000 claims with a settlement on the day of the Employment & Training Administration release of the weekly report.
The ability to purchase a binary option on an individual stock is not available on a U.S. exchange. However, foreign brokers generally offer options on individual securities of large corporations such as Google and Apple.
2. Option Term and Expiration
The appeal of binary options is the opportunity to trade with a defined risk on a short-term basis, albeit with a capped profit potential. The term is the period of time between the purchase date and time of the option and the expiration date and time that the option becomes void and ceases to trade (expiration date). Binary options generally have terms shorter than traditional options, such as 60 seconds, 15 minutes, 30 minutes, 45 minutes, one hour, and one week. At the expiration date, the binary option pays either the contract value ($100 on the Nadex) or nothing, depending upon whether the trader has correctly projected the direction of the price for the specific underlying asset by the time of expiration.
Owners of an American binary option can sell their option at any time before expiration. In other words, if the price moves in the direction expected by the option holder before the option expires, they could close the trade by selling their option, since there is no additional financial benefit to continuing to hold the option and exposing the holder to the risk that the price would reverse. Traders who purchase options from foreign brokers may not have the ability to close a trade before its expiration date.
3. Strike Price
The strike price on the binary option is the price that determines whether the option is in the money (a winning trade) at expiration. Traders can select a range of strike prices equal to, above, or below the market price at the time of the trade.
For example, a trader might purchase a binary option on the direction of the S&P 500 market index in the next 30 minutes. At the time of the purchase, the S&P 500 is quoted at 2,071.5. The trader, believing that the price will stay stable or increase during the option term (30 minutes), buys an option with a strike price of 2,070.0. As long as the underlying asset’s price remains above 2,070.0, the trader will win. If the underlying asset – the S&P 500 – falls below 2,070.0, the trader loses.
4. Price Direction
Binary option prices reflect investor sentiment about the direction of the price of the underlying asset during the option term. The profit potential is the difference between the cost of their positions and the payout, and investors can place a trade that pays out if the underlying increases, just as they can place a trade that pays out if the underlying decreases.
The outcome of a trade does not vary by the magnitude of a price move away from the strike price. Whether the move is 1/16 of a point or 100 points in the correct direction does not matter – the payoff is the same. Purchasers of binary options on the CX or Nadex can close their positions at any time prior to expiration by selling their options. However, due to the short duration of most trades (one-hour options being the most popular duration, followed by 20-minute durations), many traders do not close their positions prior to expiration. When the option expires, the exchange (in the U.S.) or the broker (foreign trades) automatically pays the winner of the trade.
5. Bid and Offer Prices
Traders buy or sell binary options based upon the bid and offer price quoted at the time of the trade. The bid price is the highest amount another trader will pay for a specific binary option, while the offer price is the lowest price another trader will pay for the same option.
For example, a binary option might have a bid of $75 and an offer of $78. A trader would buy the option at $78 or sell it at $75. The difference between the bid and offer is the “spread.” Bid and offer prices are established differently for U.S. exchange-traded binary options and binary options available from foreign brokers:
- U.S. Exchanges: The bid and offer prices on a U.S. exchange are established by an auction process where the exchange collects bid prices from all investors who want to buy an option, as well as offer prices from all investors who want to sell the option. The bids and offers are ranked from high to low, so the investor who is willing to pay the most has priority over those who seek to pay less. The same process works with offer prices, as the investor who is willing to sell for the lowest price has priority over those whose price is higher. For example, if the exchange has active bids (to sell) from $67.50 to $75, and active offers (to sell) from $78 to $85, the bid/offer price would be $75/$78 – the highest bid available and the lowest offer available. All trades on a U.S. Exchange are between an independent buyer and seller, with the Exchange facilitating the trade and collecting a fee for its services from the winning side.
- Foreign Brokers: Foreign brokers of binary options typically act as “market makers” for the options they trade. Based upon the market maker’s existing option positions, financial strength, and projection of future price direction, the broker establishes a bid and offer price. Foreign binary options are often characterized as either “calls” or “puts,” depending upon whether the purchaser is expecting the price of the underlying asset to rise or fall. Unlike U.S. exchange-traded options where the bid and offer prices are established by a public auction process, the broker establishes these prices. In the U.S., a binary option transaction always includes an independent investor on each side of the trade, whereas one side of a foreign binary option transaction is always the broker or market maker.
If a majority of investors believe that the market price is likely to close higher, bid and offer prices of the binary option will be closer to $100 on Nadex where contracts are valued at $100. If the majority of investors believe the market price will be lower, the bid and offer price of the option will be closer to $0. If there are a near-equal number of investors on either side, the bid and offer price will be around $50.
6. Contract Values or Payouts
The contract value is the payout for a binary option, established when the option is purchased, and does not vary during the option term. The payout is effectively all or nothing. If your strategy is correct, you receive a fixed amount, the specific value depends upon the exchange (Nadex is always $100 or $0). If you are wrong, you lose all of your investment. Bid and offer prices will continue to fluctuate until the option expires.
Traders of U.S. Exchange-traded options can close their position at any time before expiration to lock in a profit or reduce a loss by selling their position. Some foreign brokers may allow exercise before expiration as well. However, in those cases, profit and loss will be determined by the difference between the cost of the option and the proceeds of a sale of the options at that time, rather than the contract value.
The price paid for the option affects the percentage return or lost on the trade is illustrated by the following basic example (without considering the spread). The example is of a binary option on the Nadex on gold at the current market price of $1,217. To recap, contract value on the Nadex is either $100 or $0. If gold is above $1,217 at expiration, the contract is worth $100, if it is less than $1,217, the contract is worth $0.
A buyer of a Nadex binary believes the price will increase above the strike. A seller, however, believes the price will be below the strike price at expiration. Buyers and sellers of binary options are paired on the Nadex, so an investor who believes gold will decrease below $1,217 would sell that binary (with a $1,217 strike price) to a buyer who believes it will increase above the strike. If the binary option has an offer of $27, a buyer purchases for that amount. Technically, a seller “sells” to the buyer for that amount – meaning the seller would receive $27 and potentially have to pay $100 to the buyer (in case gold is above $1,217 at expiration). Since the seller is risking $73 for a $27 profit (a contract value of $100 minus the sales price of $27), he or she has to provide $73 in collateral, while the buyer only provides $27 in collateral which represents his or her potential loss.
The collateral amount is each investor’s upfront investment in the trade. A buyer of a binary option expecting the market to rise above $1,217 would buy the option at $27, while a trader expecting the price to fall would sell the option for $27 (each transaction has to have a buyer and a seller). Each trader would have to collateralize his or her trade by depositing funds with the broker or exchange to cover the assumed risk of the transaction – $73 for the seller, and $27 for the buyer.
The trade can work out in one of two ways:
- If gold’s price at expiration is higher than $1,217, the profit for those who bought the binary option at $27 will be $73. They would receive $100 (the value of the contract), but paid $27. In other words, they risked $27 to win $73, equivalent to a return of 270% ($73/$27) for the trade. Those who sold the option would have a loss of $73.
- If gold’s price at the end of the hour is lower than $1,217, those who sold the binary option at $73 will receive $27 ($100 minus the collateral of $73), while those who bought the binary option would have a loss of $27. The seller’s profit would be $27 while risking $73 for a return of 36.9% ($27/$73) for the one-hour trade.
7. Fees and Commissions
Fees on the Nadex are $0.90 per contract for up to 10 contracts, with a cap of $9 per trade. There is no additional charge for the number of contracts greater than 10. Buyers and sellers pay the fee when opening the trade.
Additionally, a $0.90-per-contract settlement fee is taken from the winning side of the trade when it is closed or expires; the losing side pays nothing. The fee is also paid if the option is exercised before the expiration date.
Since most foreign brokers pay a discounted value of the contract to winning traders, there are typically minimal or no fees to open an account or trade binary options.
American Exchange-Traded vs. European Broker Binary Options
While there are similarities between binary options traded in the United States and those traded off-shore, there are substantial differences that affect binary option traders.
American Binary Options
The bulk of binary options trades in the U.S. occur on the Nadex or Cantor Exchange, the only two exchanges licensed by the CFTC in the United States. Contracts are priced at $100 on the Nadex and $1 on the Cantor Exchange. The difference in contract value is not representative of a benefit of either one over the other.
Unlike the other regulated exchanges, neither Nadex nor Cantor is a member of the Options Clearing Corporation, the world’s largest equity derivatives clearing organization, since both exchanges function solely as an intermediary to bring buyers and sellers together. In effect, customers of Nadex or CX become members of the respective exchange. Returns are guaranteed by the exchanges requiring cash deposits before accepting any trade.
European Binary Options
Americans can also trade binary options through a foreign account with an SEC-registered broker. While it is technically legal for a U.S. citizen to contact a foreign broker and make an unsolicited trade, many foreign brokers refuse to accept American accounts.
Since the SEC’s intent is to protect investors from unscrupulous dealers, wise investors should use an SEC-registered broker for all transactions. Americans wishing to trade in binary options on individual stocks would need to open an account with a foreign broker.
According to BinaryTrading.org, there are two legit and legal foreign sites available to Americans:
- MarketsWorld. Licensed and regulated by the Isle of Man Gambling Supervision Commission, binary options are available for various international stock indices, as well as Forex spreads and commodities. The broker charges a flat fee of $1 on trades and charges no other commissions or fees.
- Finpari. Established in 2014, this broker offers binary options on individual stocks of large established international companies (such as Apple, Microsoft, Tata Motors, and Citi), stock indices, currencies, and commodities. Finpari charges no commissions or other expenses.
Market Makers in European Options
Unlike U.S. binary options traded on the Nadex or CX, where both sides of a trade are members of the exchange where the trade occurs, European binary options are between the buyer or seller of the option and a broker who functions as a market maker setting bid and ask levels. European binary options have the following characteristics:
- Available for a broader range of underlying asset types including individual stocks, as well as multiple strike prices and durations.
- May not be exercisable during their term, but must be held until their expiration date. At that time, options that are “in the money” – above or below the strike price – are automatically paid the pre-specified profit defined in the contract.
- Have a fixed payout that is a percentage of the contract value, rather than full value. For example, owners of a binary option in a foreign account that finishes in the money on expiration might only receive 60% to 70% of the contract’s value. As a consequence, foreign account purchasers of European binary options must be right almost two-thirds of the time about the direction of the market just to break even and compensate for the lower payouts.
- Bid and offer prices are established by the broker or market maker, rather than the auction process between buyers and sellers on a U.S. exchange. As a consequence, Philip Masters of Binary Options Wire claims, “The price that binary options brokers quote is also influenced by the open positions of traders on their platform. This is so that they always make sure that more people are losing than winning on their platform and that losers lose enough to pay out the winners.”
- Foreign firms offering Americans access to European binary options typically offer credit cards as a payment alternative. Nadex and CX only accept deposits in the form of bank transfers, checks, and debit cards, thus prohibiting any leverage (borrowing) on binary option accounts.
Advantages of Binary Options
Advocates of binary options trading – most of which are brokers or advisory firms serving binary option traders – claim some advantages for the vehicle when compared to other investments. These include the following:
- High Return on Investment Potential. While the risks are higher than most investments, the return is also higher, ranging from 60% to 100% of the initial investment.
- Known Risk and Reward. The cost and payoff of the investment are established prior to making the investment. You know exactly how much you can lose and how much you can make if your prediction of the market direction is correct. Some brokers even credit losing trades with new equity equal to 10% to 15% of the investment, although such credits cannot usually be withdrawn from the account.
- Easy to Understand and Trade. Unlike standardized options, which can be complicated with various investment consequences, an investor either makes money or loses his investment. There is no need to use stop orders or consider the magnitude of a price movement.
- Faster Results. Most binary options investors trade in options with duration of less than one hour. As a consequence, there is an opportunity for more trades per day than in other investments.
- Lower Commissions and Fees. Commission fees to open a trade on the Nadex are low per contract, while settlement fees are deducted solely from the winning side of a trade. There are usually minimal or no fees associated with a foreign broker account.
- Minimum Deposits to Open Accounts. Minimum opening deposits may be as little as $100. Accounts offered are free paper trading accounts, as well as continuing education about binary options.
- Excitement. Unlike other investments, trading binary options is exciting. Due to its fast pace and unpredictability, traders report similar highs as experienced in casinos – an adrenaline rush from the anticipation of winning.
Concerns Regarding Binary Options
The line between binary options trading and gambling is blurry. According to Finance Magnates, Ilan Tzorya, CEO of one of the industry-leading technology providers TRADOLOGIC, binary options are not financial products (nor do they fit an audience in the financial sector), but are a “gaming” product. Foreign brokers offering binary options do function similarly to many gaming sites with arcade-type screens, contests, and giveaways. Thus far, neither Nadex or CX have provided such promotions.
Whether you consider binary options investments or gambling, there are several cautions to consider before venturing into the binary option market:
- Could Be Gambling. Many (if not most) investment professionals agree with the sentiments expressed by Gordon Pape. Pape claims that no one, no matter how knowledgeable, can consistently predict what a stock or commodity will do within a short time frame. As a consequence, he concludes, “If people want to gamble, that’s their choice. But let’s not confuse that with investing. Binary options are a crapshoot, pure and simple.” That is, unless, you have a tested and verified system for accurately predicting asset movement within a very short frame of time.
- Possible Addiction. Compulsive gambling is a problem for a significant percentage of the population. According to Jeremy Jenkins, a therapist at Tulsa’s Family & Children Services, a gambling addiction can be even harder to treat than drug or alcohol addiction. As a consequence, 15 of the 20 states with legalized gambling require that casinos contribute a portion of their revenues to gambling addiction counseling services. There are no similar regulations affecting binary option exchanges or brokers.
- Poor Returns. While binary options in the United States are a zero-sum game – whenever someone wins, someone loses – offshore binary option brokers pay a portion of the contract value, rather than the full value. For example, a losing trade is a 100% loss (all of the contract value), while a winning trade may only pay 60% to 70% of the contract value. Suppose a website pays $70 for each successful trade. If you make 100 trades and win 55 of them, your profit would be $3,850. However, your losses would be $5,000. A trader in European binary options would need to be right almost 59% of the time to break even, effectively giving the broker a 9% edge. An edge this large would be comparable to the house edge on the dice game of craps to roll a pair of threes (hard six) or a pair of fours (hard eight).
- Little Value as a Hedge Against Losses. Unlike standardized options, which are often used to protect gains or hedge against losses, binary options have no use as a hedge instrument due to their fixed payouts and short durations.
- Difficulty Withdrawing Funds. Some brokers may require a significant trading volume or that the account be active a minimum number of days before allowing withdrawals. Restricting withdrawals is more common by foreign brokers who frequently offer traders “bonus” funds to encourage trading. According to Abe Cofnas of Futures, the result is “a very low statistical probability of ever getting any money back.”
- Lack of Regulation of Foreign Brokers. Many of the binary option firms are licensed overseas and not subject to the rules and regulations that are common in the United States, Europe, and Australia. According to a fraud advisory from the U.S. Commodity Futures Trading Commission, both the CFTC and the SEC have received numerous complaints about brokers failing to credit customer accounts and refusing to reimburse funds. They have also received complaints regarding identity theft and the manipulation of software to generate losing trades.
Binary options are simple to understand and easy to trade. As a consequence, they are primarily attractive to beginning investors, as well as gamblers seeking a rush. Before visiting the fast-paced environment of binary options, be sure you understand the risks and temptations.
Follow these rules and you will avoid major disasters:
- Trade with a reputable exchange and broker.
- Avoid extremely short duration periods, such one to five minutes. Since you can exercise the option throughout the duration, let time work on your side.
- Know the odds and never trade more than you can afford to lose.
- Never borrow money to trade in binary options.
- Seek professional help if you feel your trading is out of control. Periodically take the Gamblers Anonymous confidential test to identify possible problems.
Have you traded binary options? Was your trading experience positive?