The size of binary options market has skyrocketed since 2008. That was the year when the Securities and Exchange Commission approved these type of options for trading.1
This has led to the proliferation of binary options trading all over the internet. Case in point, a Google search for ‘binary options trading’ displays almost 22 million hits today.2
What is a Binary Option?
The foray into exotic investment products continues. A relatively new investment product called a binary option has become increasingly popular over the last few years. This can be attributed to, at least partially, to a bombardment of television advertisements on financial news channels.
As the name suggests, a binary option is a type of option where an underlying statement (called ‘proposition’) has only two potential outcomes, either it happens or it doesn’t. If you agree that the statement will happen, you indicate ‘Yes’ by purchasing of a Call option. Conversely, the purchase of a Put option indicates a “No” response. Think of it like an old math class where a number equation is listed and you have to answer whether the statement is true or false. Except with binaries, you must predict whether it will be true or false. The underlying propositions often relate to prices of financial benchmarks including the S&P 500, Japanese yen or gold.
A Binary Option Example
Here is a hypothetical binary option example (taken from the NADEX website)3:
“Gold (Dec) > 1794.0 (1:30 PM)”
This proposition says that at 1:30 PM today, the price of a December Gold futures contract will be above $1794 (per ounce). You predict that since the overall stock market looks very weak, investors will buy gold as a safe haven, pushing gold prices higher (above $1794). Because you agree with the proposition, you buy a call option on this binary option contract. Again, you are selecting that December gold futures will be greater than, but not equal to, $1794.0 by 1:30 PM. Conversely, you can indicate “No” to the proposition by buying a put option.
You decide to buy one call option contract costing $21. When purchasing the option, the broker’s platform displays the maximum amount you can gain if your assertion is correct (known as the payout). In this example, the payout is $79 (if you’re right). The most you can lose is the initial $21 (plus fees). As you can see, the payout is almost 4x your initial price for the option, which indicates that the probability of the proposition being correct and gold being above $1794 by 1:30 PM is a bit of a “long shot”.
In the example, the NADEX has the “official say” on the price of gold at 1:30 PM and calculates the values of the options and payouts. If this sounds a little too cozy, the price is mainly determined using Bloomberg and Reuter’s time and sales data. Often, trading can be frenetic right around an options expiry so this is why they act as the referee in determining the price.
Where can you Trade Binary options?
You can trade binary options directly through binary exchange NADEX (North American Derivatives Exchange). There are also several different exchanges abroad, including many based in Cyprus and Malta.
There is no shortage of brokers offering binary options trading. These include more obscure names like ZoomTrader, Binary Brokerz, Porter Finance and BinaryTilt.4 Following the lead of traditional brokers, some sites also offer free commissions on binary trades. All these different websites offer different underlying propositions to trade. One site may focus on economic data being released while another may focus on commodity prices.
Binary Options Controversy
If you are interested in binary options, there are some risks you need to consider. According to the CFTC, binary options brokers may exaggerate the advertised average return on investment (an advertisement from one binary option firm boasts you can “earn up to 75% every hour”).5 The CFTC uses the example that a binary option investor’s odds of being right are 50/50 but the payout on a winning trade might be just 50%, while the loss would be close to 100%.6 So the loss doesn’t hurt so badly, some brokers may ‘refund’ between 5 and 15% of losing trades to customers. Still, binary options don’t sound like a very good long-term trading strategy and surely wouldn’t be endorsed by any Certified Financial Planners, CFPs.
One key distinction between binary and traditional options is that binary propositions can be more esoteric, including non-tradable financial instruments like economic data (i.e. the Federal Funds Rate or jobs reports). This is one reason critics contend that this is the same as gambling. Some also fear these brokers prey on individuals. NADEX’s own site refers to them as a “retail-focused exchange”. This could mean that institutions aren’t interested in this type of ‘investment’ or the related stigma and fear of litigation.
There are also concerns of fraud in the industry. If you wire money into an offshore binary options account, your funds are probably not segregated, which would be illegal under U.S. law.7 Globally, there have been numerous cases of unlicensed activity by binary options firms, notably in Spain.8 This is worrisome in case of banks or financial institutions failure.
How are Binary Options Regulated?
In their defense, the NADEX website contends that binary options have transparent trading fees, limited trading risk, low collateral requirements and legality for U.S. residents.9 NADEX’s website also reports that they are regulated by the CFTC (Commodities Futures Trading Commission) with depositor’s funds held at a U.S. bank.10 Still, the SEC has issued an Investor Alert on binary options.11 They assert that investors should proceed with increased caution, although they’re not prohibiting binary options. With regards to binary options, the SEC also suggests that you check the registration status and background of any entity you consider dealing with at the National Futures Association’s website www.nfa.futures.org/basicnet.
But if the exchange or platform is unregulated or offshore, there’s no telling how safe the account is. Many binary options exchanges are hosted in Cyprus, the tiny island off the coast of Turkey. The island’s banking system doesn’t have the greatest track record (recall depositors took a haircut on deposited money above their insured level) 12. Malta, another popular location for binary options, is regulated under the jurisdiction of the European Union or EU.
The Future for Binary Options
Binary options join an exotic investment club including leveraged exchange traded funds, collateralized loan obligations, bitcoin funds and ‘pay in kind’ bonds. Increasing regulatory oversight has been an ongoing theme in finance since the financial crisis and you can expect this to continue for binary options.
Still, what critics view as gambling has found remarkable staying power. There is a trend towards gambling deregulation, nationwide. So whether binary options are classified as gambling or under the umbrella of financial instruments, binary options are probably here to stay in the United States.
Globally, the expansion continues in full force. Technology provider Hello Markets announced it is opening an office in mainland China to capitalize on the potential growth of binary options and foreign exchange trading.13 Cyprus-regulated binary broker, ‘anyoption’, has expanded into South Africa, opening a physical office in the country. As acceptance of binary options grows, there should continue to be financial career options in the binary options space, both on the business development and compliance sides.