2. All About Binaries
The essence of binary options is that the outcome of the trade i.e. the return to the trader, is one of two values – either 1, where 1 represents the original amount placed at risk (or some pre-agreed percentage of this amount), or zero. It is this feature that gives the name ‘binary’. So, a trader knows precisely, in advance, the potential loss and the potential gain. The trade is either a win or a loss and the value of both are known in advance.
The trader has 3 decisions to make when considering a trade.
It all sounds very simple and it is this simplicity that may carry the greatest risks for the unwary trader.
Binary Options trading has only been around as commonly used trading vehicles in the sense in which they are described in this eBook for a few years but the size of trading in the market has grown rapidly1 . It’s not difficult to see why as there are a number of benefits from the point of view of a private trader, particularly a trader with limited experience in the financial markets.
It all sounds like Binary Options are a very attractive way to trade, and they can be. However, there are drawbacks.
The first is that the sector has been subject to some unscrupulous operators who, because of the simplicity of the trading, have been able to con inexperienced traders out of their money. This is the first risk a trader faces – broker risk. There are many ways of doing this and we discuss this in more detail in Chapter 3, but it is up to each trader to choose a broker carefully. There are also legitimate differences between brokers that need to be considered and we discuss these below.
The second issue also arises from the simplicity and accessibility of the markets using binary options. This is that new traders can be lulled into over-trading i.e. placing too much of their fund at risk at any time. This may arise from opening too many trades or from placing too high an amount at risk. This is financial risk and, unlike broker risk, this is wholly addressable. Indeed, controlling financial risk through good money management is one of the few aspects of trading, along with deciding what market to trade and in what direction, that is fully under the control of a trader at all times. Therefore, since a trader cannot control most of the factors that will determine results it is vital that he does manage what is under his control. This important area is addressed in Chapter 4 below.
The third drawback arises from the way in which brokers offering over-the-counter (OTC) Binary Options, a very popular and rapidly growing section of the make, earn their profits. Unlike most financial instruments, there are no commissions, no bid-offer spreads and few administration costs associated with these Binary Options. Brokers earn money by means of the payout ratio. This is typically in the range of 70% to 82% depending on the broker and the underlying market being traded. What this means is that when a trader is correct about a market and places a trade, the broker retains this percentage of the winnings as payment for the service. Usually, if the trade loses then the broker retains all the stake, although there can be exceptions. This has important implications for traders as discussed below.
Types of Binary Options
There are three different kinds of products that are marketed and traded as Binary Options. The differences have arisen primarily in response to regulations and traders need to be aware of what they are dealing with. All types have an outcome that is one of two possibilities and all require that the trader correctly predicts the movement of the market. However, there are important differences.
The first, and best established type, are described as exchange traded options and sometimes as US-style Binary Options. A key feature of these options is that they are regulated by the US Securities and Exchange Commission (SEC) and so they can be traded legally by US residents.
Assuming you hold to expiry, if you buy an option, the outcome is one of two events – you either win $100 or you lose your stake. If you sell the option, you could earn the price at which it is sold at or lose up to $100. However, you can also cash out early to take some profit or cut losses. These Binary Options have many similarities with more mainstream instruments. A trader can purchase an option, sometimes described as a contract, with a future expiry time at a price that is determined on an exchange. This price will always be in the range of zero to $100 and there is a bid-ask spread.
The basic decision is whether the value of the underlying security will be above or below a stated level at the time of expiry. So, if you are buying a call and the current market price is moving up towards the target price then the price of the option will move closer to $100 and will continue to do so as the expiry time moves closer. This is a straightforward reflection of market demand and supply – the price is reflecting the risks. The reverse will also be the case.
Brokers are only allowed to market exchange traded Binary Options to US residents, although there have been many reports of this regulation being flouted. Until relatively recently, exchange traded Binary Options were provided to US residents by the NADEX platform only. However, competition has emerged with the Cantor platform and a number of companies that had previously existed only as providers of OTC options are now using this platform to provide SEC regulated options in the US. Regulators in other countries, most notably Japan, have also begun to adopt this approach in recent years and so the use of this type of Binary Options is likely to grow.
The second type of Binary Options is described as over-the-counter (OTC), or sometimes European-style, Binary Options. These have been growing rapidly in recent years since they are very customer friendly. Many consider them to be a form of gambling but a growing number of countries have begun to regulate them as financial products. The most important source of such regulation have been the Cyprus SEC (CySEC). Since Cyprus is a member of the EU, this means that these products are thereby regulated in every EU country and can be marketed throughout the EU. They have also proven popular in countries such as Australia and Canada with varying levels of regulation.
With OTC options, the broker provides a price, which is considered to be the market price, and will be the price at entry – or strike price – if a trader buys an option. There is no option ‘price’ as such but instead the trader decides how much money to put at risk. If the trade wins then the trader is returned the stake plus a stated percentage of the stake. If it loses then the stake is lost.
It’s easy to see why these are proving to be so popular among new traders since the risk is tightly limited and easy to understand, and there are no further decisions in relation to exiting the trade or stop losses. The trade is held to expiry and it either wins or loses. Many have raised concerns about the lack of transparency in the underlying pricing and the potential for brokers to manipulate the stated prices. However, there is no definitive proof that this is being done or even that it could be done as a profitable strategy. Despite this, the attractiveness of these products to new traders allied, to some very aggressive marketing and a lot of nonsense on the internet about the potential to earn big profits, has meant that concerns remain that people can effective treat this type of instrument as gambling.
Traders need to consider the implications of this structure. If you trade randomly then you should expect to be right 50% of the time. After all, you are only required to identify if the market will rise or fall. If we ignore the occasional times when a market will end exactly flat there are no other possibilities.
So, if you always risk $10 and trade an instrument with a payout ratio of 75% then over a number of trades you will win $7.50 per trade on half of them, and lose $10 per trade on the other half. Your expectation is that you will lose money and if you keep it up you will lose all your money.
So you need to shift the odds in favour so that you win in excess of 50%. This is trading risk and shifting these odds and trading accordingly is effectively the sole requirement of a trader.
The third type of Binary Options is exactly the same as the OTC options discussed above except in one important respect. This is that they are offered by brokers that are not regulated. This is a big concern. The relative ease of accessing the required technology and ease of marketing what appear to be attractive opportunities for profit has meant that a lot of unregulated firms have begun to offer OTC products. Usually these are fraudulent operations and traders have found that it is impossible to withdraw funds, even if the trader appears to have been trading profitably. More commonly, the funds are traded by a ‘robot’ or ‘;expert’ and lost or some other restriction, often allied to a bonus, means that the funds cannot be withdrawn. Traders should be aware that these actions are not necessarily illegal and may be undertaken by regulated brokers but the trader must be clearly informed in that case. With an unregulated broker there is no such protection.
No matter what type of option is traded, the trader need a strategy. The strategy in relation to unregulated brokers is very simple. Have nothing to do with them. They will take your money. You will lose. So ensure that the broker is regulated. More on this later.
Placing a Trade
When you go to put on a trade, you will need to decide the following:
OTC Binary Options are unlike other products and so it is worth outlining how they are traded. Let’s assume you have made some decisions so that you are going to
We will not concern ourselves here with how we arrived at these decisions nor how we might decide on the direction or time period, these are questions covered in later chapters.
You will need to enter an amount of money representing the stake in the appropriate place on the broker’s platform. The screen grab below is one example of a brokers platform and you can familiarize yourself with others by looking around2 . In this example a value of $10 has been entered. When you open an account this will often be displayed in your own home currency so there is no additional risk involved.
The question asked is ‘will EUR/USD go up or down?’ When you answer this, your answer relates to a specific point in time, usually in the near future, although you can vary this length of time. This time is known as the expiry time or date. In this example it is 10:50. This is 10:50 am today since the platforms generally adopt the military style 24-hour clock and would give a different date if the expiry was not today but at some future date.
The next piece of information to look at is in the box containing the number 1.35293. This tells us that the Euro is currently worth 1US$ and 35.293 cent. This number will change from moment to moment and, if you take a trade, at the moment you do so its value is the strike price. You are being asked to decide if the expiry price will be higher or lower than the strike price. So, in this example, you must decide if you think that at 10:50 today, which was 3 minutes and 28 seconds after this grab was taken according to information in the bottom right hand corner, the Euro will be worth more or less than 1.35293US$.
If you think the value will be higher then you will trade a call option by clicking on the green box. If you think the value will fall then you will trade a put option by clicking on the red box. That’s the first question answered, although when you are trading you will not necessarily make your decisions in this order.
There are 3 other pieces of information provided on this screen grab. The first is the graph that comprises a simple line chart of how the market has been performing. This chart shows a minute by minute line stretching back for an hour. You can adjust this on the platform but I’m not sure how useful a chart such as this actually is to you in making your decisions.
The second piece of information is below this and comprises a red and green bar which shows the percentages of traders that have been buying calls and buying puts over this time period. Again this can be worth a look, but is not all that important.
The final set of information is in the box on the right and is important. This gives the payout ratio for this market. It tells us that the payout ratio for the EURUSD was 81% at the time the grab was taken. This tells us is the percentage of our stake that will accrue as profit if we are correct. If you look at the number at the top of the box it is $18.10. This is because I chose a stake of $10 for this example. So, if I am right I will be returned my $10 stake plus 81% of $10 giving total of $18.10.
Clearly the payout ratio is an important factor in determining your returns and something that brokers compete on very vigourously. You should take it into account in deciding what you will trade and with which broker, but it should not be the deciding factor in your trading. This is an important factor that we return to below.
Having entered your stake, and decided on the market and the time period, it is now just a matter of clicking with the red or the green arrow to place the trade. All platforms follow these general formats, although designs vary. However, you are always required to make exactly the same decisions.
Trading exchange traded Binary Options is more similar to mainstream products in that you see a price and you buy or sell a certain number of options or contracts according to the amount of money you wish to invest. You can then hold the options for as long as you wish. Unlike OTC options you can cash out at the market price at that time any time before the expiry time. This allows you to cut potential losses if you see a market breaking in a direction against your trade. While some OTC brokers offer a possibility to do this it is usually at a pretty high cost and should not really enter into a traders strategy to any extent.
Binary Options differ from other options you might buy in an important respect as your potential winnings and losses are both known in advance. This makes them a relatively low risk instrument as there is no margin involved, provided you have traded according to good risk control rules. These are discussed further below.
And that’s all there is to it. Except that we haven’t said yet how you should make the decisions!