Every investor looks for ways to grow their capital, but some investors are willing to incur a greater level of risk than others. While high-yield savings accounts cater to people with a low risk tolerance, binary options trading attracts speculative investors who have a high risk tolerance.
Individuals who have traded options may be intrigued to learn about another type of options trading. However, it’s important to note that binary options trading carries even more risk than traditional options trading.
A typical option is a contract between two parties that secures for the option buyer the right, but not the obligation, to buy or sell a quantity of an underlying asset at a specific price within a set amount of time. Options are a type of security, but because they derive their value from other assets, they are also classified as derivatives.
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Rather than being tied to an underlying asset, binary options are purely speculative, with a set maximum payout and the risk of potential total loss. Stephen Callahan, trading behavior specialist at Firstrade, offers a brief explanation of why binary options trading isn’t for everyone: “Binary options are called ‘binary’ because there are only two possible outcomes: Either the trader wins a fixed amount of money, or they lose their initial investment. It is an all-or-nothing outcome.”
If you’re still curious about binary options trading, here are the basics you need to know:
— How binary options work.
— Factors that influence binary options prices.
— Binary options trading vs. traditional options trading.
— Binary options aren’t accessible everywhere.
— What to consider before trading binary options.
How Binary Options Work
Binary options let you predict if an event will occur, and if you’re right, receive a payout. You’re essentially making a short-term bet on a certain outcome instead of investing in a long-term asset. Some predictions resemble traditional options, in the sense that you may be betting that the S&P 500 will gain 100 points next week. However, you can also use binary options for speculation on a wider range of events.
For instance, binary options based on the CME Hurricane Index may let people bet on how much damage an Atlantic hurricane will cause. Speculators track a hurricane’s maximum speed, radius and other metrics just as regular investors look at a stock’s price-to-earnings ratio and financials.
Binary options are similar to sports betting apps. When you bet on a sports team or a player’s performance in a game, you’ll either receive a fixed payout or lose the entire bet. In fact, if you are familiar with sports betting, there isn’t much of a learning curve for binary options trading.
Binary options trading is also a zero-sum game. When one person wins, another individual loses. David Materazzi, CEO of Galileo FX, an automated trading platform, compares binary options trading to gambling: “Binary options trading is a coin flip, plain and simple. You’re not investing; you’re gambling. You predict if an asset’s price goes up or down, and if you’re wrong, you lose everything. There’s no ownership, no growth, no long-term value: just a bet.”
Factors That Influence Binary Options Prices
Binary options are known for their volatility, but there are a few factors that determine a contract’s price. These are the components that come into play for each binary option:
— Expiration date. How much time is left before the option expires?
— Probability of an event. Events with a higher likelihood of occurring don’t offer as much of a payoff compared to underdog scenarios.
— Volatility. Greater volatility across the underlying market will increase contract prices. When volatility decreases, contract prices decline with it.
— Underlying asset. Changes to the binary option’s underlying asset will affect the contract’s price.
Binary Options Trading vs. Traditional Options Trading
Both binary options and traditional options come with sharp volatility. A contract can quickly gain value or become worthless based on a single news item. However, binary options trading offers less room for error. While you can buy a traditional option that expires in more than a year, most binary options have shorter windows before they expire.
“One key difference is the short-term nature of binary options: They typically have very short expiration times, ranging from a few minutes to a few hours. In contrast, traditional options can expire daily, weekly or monthly, and LEAP options can have expirations that extend several years from purchase,” Callahan explains.
It’s possible to close a binary option position before it expires, just like with a regular option. This flexibility allows traders to lock in their gains instead of risking that they lose their entire investment. Some traders opt to lock in a 20% gain instead of taking a double-or-nothing approach. However, binary options don’t give you as much time before expiration. Traditional options are better for risk management.
Another key distinction is that only traditional options give you the potential to own an asset. You can exercise a call to buy 100 shares of the asset at the designated strike price. Traders who exercise their options benefit from any upward movements in the asset’s price, and they can also shield themselves from short-term capital gains taxes.
However, you can’t gain ownership of an asset through binary options. Any winnings are treated as short-term capital gains. Your gains are also limited with binary options, as the maximum reward is fixed. Traditional options give you the potential to realize unlimited gains as long as the underlying asset continues to move in your favor.
Binary Options Aren’t Accessible Everywhere
Most binary options trades take place on regulated exchanges. That’s also true for traditional options, but several countries that allow traditional options trading have banned binary options trading. Sunil Kansal, head of consulting at Shasat, a U.K.-based financial consulting firm, provides a quick breakdown: “In the U.S., binary options can only be traded on regulated exchanges (e.g., Nadex and Cantor exchanges). However, in the U.K. and EU, binary options for retail investors are largely banned due to their high risk, with ESMA (European Securities and Markets Authority) imposing restrictions.”
Kansal warns that binary options “are often associated with unregulated brokers, increasing the risk of fraud.” The high-risk nature of binary options combined with the risk of fraud explains why some countries have banned them entirely. However, the U.S. and some other countries allow these derivatives as legitimate ways to make money.
What to Consider Before Trading Binary Options
Binary options trading can lead to quick wealth accumulation if you guess correctly enough times, but it is a high-risk proposition. Before making any investment, it’s good to consider how the asset aligns with your long-term financial goals.
While index funds and exchange-traded funds, or ETFs, don’t have as much potential in the short run, they can move you closer to your financial goals in the long run. Those investments are also more likely to generate a profit than binary options trading.
Materazzi doesn’t mince words when describing the probability of making money with binary options: “Let’s be clear: Binary options are a shark tank. The illusion is quick money; the reality is you’re likely to get eaten alive. Brokers profit whether you win or lose, and they stack the odds against you. People get hooked by the myth of fast gains, but it’s a trap. ‘Bulls make money, bears make money, pigs get slaughtered’ … unfortunately, binary traders are often the pigs. If you want to build real wealth, stick to real investing.”
The line between investing and gambling can sometimes get blurry. Unfortunately, when those lines get blurred, individuals can end up with substantial losses. Investors who are focused on securing the next big win may not accept that their steady losses are hurting their long-term returns in comparison to benchmarks like the S&P 500. Meanwhile, they are incurring fees for each binary options trade and that can add up quickly.
“People who think they’re traders with binary options are fooling themselves. It’s not investing; it’s a game of chance rigged to benefit the house. It might look like the stock market, but it’s closer to the casino,” Materazzi explains.
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What Is Binary Options Trading? originally appeared on usnews.com
