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Binary options are investment contracts with a simple true or false outcome, such as if an asset price will increase above a specific value or drop below a pre-agreed amount.
Investors buy binary options, which are executed automatically depending on the outcome. When a binary option expires, the holder receives nothing if the forecast is incorrect or a fixed value payout.
Traders can speculate on various events or investments, including futures, stocks, forex, and ETFs. Still, the difference from standard investment structures is that you pay a fixed price for the option and receive either a specified payout or zero.
Binary options can run across varying periods, from a few seconds to several days.
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Binary Options Explained
Binary options are banned in the UK for retail investors but are traded within the US through three exchanges, each regulated by the Commodity Futures Trading Commission (CFTC) – Nadex is the largest exchange retail investors use.
All binary options cost from $0 to $100, but if you open a trading account with Nadex, the minimum deposit balance is $250.
Because there are no margins in binary options, you must always have the funds to cover your option cost and the associated trading fees. The benefit is that the risk and possible gain are included in the trading terms, so there cannot be an unexpected outcome – either one or the other.
While binary options are sometimes considered controversial, they are commonly used in biotech stock trading, where investors will buy an option when a pharmaceutical company announces the results of a major clinical trial.
Traders can also use binary options to speculate about how the broader stock market might move or how the value of specific securities will change. Rather than buying shares, they pay an upfront price for the option and know the exact amount they can lose or gain.
How Binary Options Work
Most binary options trading is concentrated outside the US and UK, and each trade has a definitive expiry time or date. The strike price is based on the trade, and when the option expires, the investor makes a profit if the underlying asset is on the right side of the strike price – depending on which way they are betting.
Binary options can be simple, such as speculating that a share price will be higher than $50 at midday on a specific date. They can also be more complex, although they rely on the same all-or-nothing profit model. Traders can make directional or sideways movement bets or use binary options to trade volatility.
For example, an investor might use binary options to limit their exposure while trading based on underlying market directions during periods of significant fluctuation. However, the potential to make a loss is higher than in more stable market conditions.
Trading binary options outside of the US can be high-risk, given that unregulated brokers do not conform to any trading standards, and there is a potential for fraud.
The Issue With Binary Options
Binary options were banned for sale to retail investors in the UK by the Financial Conduct Authority (FCA) in April 2019, which labelled binary options as an ‘inherently flawed’ investment and a disguised form of gambling.
They have also been prohibited in the European Union at times by the European Securities and Markets Authority (ESMA). However, the most recent ban expired in 2018 and applied only to retail investors.
Unregulated binary options trading has led to high levels of fraud, with online trading sites retaining investors’ money but refusing to pay out once the contract expires. Other criminal activities linked with binary options trades include
- Identity theft, with online-based platforms collecting credit card details and ID documentation.
- Software manipulation to adjust the prices and payouts of binary options, such as extending the expiry date indefinitely to ensure that the contract expires when the trade becomes loss-making.
- Overstating investment returns, advertising fake profit forecasts, and encouraging traders to invest more in a binary option that will create a net loss.
Traders considering binary options should always use a regulated, established broker or financial professional and avoid trading through any unregistered platform.
Non-US Binary Options
Binary options are available outside the US but traded with a different structure. However, regulators remain sceptical about the outcomes even though these options have clear strike prices and expiry dates, as many foreign platforms still need to comply with US investment rules.
The simplicity of binary options makes them popular with retail investors, but the published information can be deceptive.
Most non-US binary options involve a strike price fixed at the current rate or based on the underlying value of the financial product – the investor is therefore betting on whether the value at the expiry date will be above or below the current price.
Payouts remain fixed but are usually offered by individual brokers rather than larger exchanges, and the broker keeps the deposited funds until the expiry date.
Overseas brokers can only advertise to US residents if registered with a domestic regulatory body.
US Binary Options
Within the states, traders and brokers are still only legally permitted to provide traders with binary options if they are correctly authorised. The yes/no proposition remains the same, although you can purchase an option with capped risk or potential.
Traders set the bid and ask price themselves and need to use judgement and knowledge to determine whether the probability calculated by the platform is correct. Investors can close a position at any point before the expiry date to validate a profit or mitigate their loss exposure.
There are multiple potential asset classes, including:
- Dow 30
- S&P 500
- Nasdaq 100
- Russell 2000
Investors can also buy binary options based on global indices, such as the FTSE 100, Germany 40, China 50, and Japan 225.
Day traders can use binary options to generate returns by speculating on market direction over short time frames or use options to hedge other trades in stocks, forex, or commodities.
US trading exchanges are regulated and provide real-time data on all trades, bids and offers throughout each trading session so investors can make informed choices about any binary options.
Binary Options FAQ
Binary options are illegal in the UK, following a ban imposed by the financial regulator, but this only applies to retail investors. The FCA believes these products carry higher than acceptable risks and permanently prohibited binary options in 2019.
The FCA extended the ban to all securitised binary options, which cannot be sold to any investor, as it concluded that the risks are inherent. There is a large potential for traders to make unexpected losses due to unethical trading practices.
Part of the rationale is that the true or false model means that binary options act more as a form of gambling than a true investment and are attractive to inexperienced investors who see the simplicity and mitigated loss as an easy win – which may not be.
Despite the controversy, investors can consider binary options a controlled risk trade because the maximum loss is established at the point of the transaction. Contracts show the potential loss, and the limit is the amount wagered or paid for the option.
Binary options return either a yes or no result. Hence, traders either receive an automatic payout when the contract expires or lose the money they have invested – they cannot lose anything more.
Investors use binary options to generate profits by predicting how markets, forex pairs or specific stocks will move. They select a predefined expiry date and can bet on events, commodities or theoretically any financial asset.
However, as with any investment, binary options can be more than a gamble if a trader speculates without any technical knowledge or data indicating their position is likely to pay out.
Regulators can regard binary options as gambling because they are sometimes advertised to retail investors likely to have very little market knowledge.
Binary options are contracts where the investor takes an option based on whether the underlying asset they are speculating on achieves a value above or below their expected price on a specific date or time.
For example, a trader could buy a binary option based on a stock’s value on a specific day – if they are correct, they receive a payout, but if wrong, they receive nothing.
The investor sets the bid and ask prices based on their assessment of the probability available.
Binary options can be traded against multiple asset classes, including forex, mutual funds, stocks, bonds, and ETFs.
Traders can take out binary options based on any underlying asset, from commodities to bonds and currencies.
Related Information
Below is a list of related articles you may find of interest.
Resources
- Commodity Futures Trading Commission (CFTC) – https://www.cftc.gov/
- Financial Conduct Authority (FCA) – https://www.fca.org.uk/
- European Securities and Markets Authority (ESMA) – https://www.esma.europa.eu/
- Nadex – https://www.nadex.com/
