I keep seeing more and more adverts for online brokerages offering so-called binary options trading as a great way to trade the financial markets and make money online. Binary options are exotic financial derivatives that allow you to bet on the price of an asset to go up or down within a specific time frame. Now, in theory, that sounds like a great tool to make money in the financial markets. However, that is not at all the case.
In fact, binary options ‘trading’ is not trading at all. It should be exclusively referred to as gambling because that is exactly what it is.
Firstly, binary options markets are – in theory – based on underlying assets, such as the S&P500, a currency pair or a commodity but in reality, they are fictitious markets made by the brokerage that mirror the underlying asset. That means that the broker has full control of the price movements (which creates a clear moral hazard).
Secondly, your odds of making money on a trade are not 50/50 (even though that is how binary options are often falsely advertised). The odds are always less than that because you have to ‘pay bid/offer’. Hence, it is no different than gambling at a roulette table in a casino. Let me explain.
How Binary Options Work
The price of a binary option is always between 0 and 100, and your online brokerage will show you a two-way price on any binary options market. The two-way price will most likely look something like this: 48.00/52.00. The 48.00 is the bid price, at which you can sell (let’s say an underlying stock index) and bet on a price decrease. While the 52.00 is the offer price, at which you can buy the stock index and bet on a price increase. So, say you place $10 per 1 unit on a price increase at 52.00, and the price does end up being in the green at the end of the investment horizon, you will make a $480 profit [$10 x (100-52)] on that trade. Adversely, if the price of the underlying stock index ends up lower, then you would lose $520 [$10 x (0-52)]. Here you can see how the odds are never 50/50 and how they are always against you.
This is basically the same as placing a bet on red or black at a roulette table. In some cases, depending on the broker’s pricing, you might even be better off gambling at a roulette table, than ‘trading’ binary options. If you were bet on black or red at a ‘European’ roulette table (those are the roulette tables with only one 0) your odds of winning are 48.6%. That means for every 1000 spins, statistically, you will win 486 times.
Regulators are not pleased with Binary Options
Regulators are keeping a close eye on binary options brokers and their marketing practices to ensure that they don’t mislead the consumer. Having said that, in March 2016 Israel has decided to ban binary options trading, while Canada is considering making the same move, as binary options are too often falsely advertised as a tool for investing when all it really is is gambling.
Similarly to when gambling in the casino, when ‘trading’ binary options the odds are always against you and you will statistically lose in the long run. Hence, I suggest you stay away from binary options ‘trading’ and instead focus on building a well-diversified investment portfolio instead.
