What are Binary Options?
Updated: 2017-10-06 10:28:01Binary Options: Options, investments, or coin-flips?
In the past few years, binary options brokers have been sprouting up like mushrooms all over the globe. It is time to look into this financial instrument and weigh its pros and cons. In this article we will explore the world of binary options and brokers that offer them, while finding out exactly what they are and if they can actually help us diversify our portfolio.
What are Binary Options?
Generally speaking, an option is a financial derivative contract that gives the trader the right to buy or sell an underlying security at a fixed price (strike price) by a certain time (expiry date) in the future.
The party holding the right is the option buyer; the party granting the right is the option seller. Looking at your standard plain-old vanilla options, there are two types: a call option and a put option. A call is an option granting the right to buy the underlying security at the strike price; a put is an option granting the right to sell the underlying security at the strike price. In traditional options trading, a trader can buy or sell an option. However, with binary options you may only buy options. The broker is your counterparty and the one selling to you.
This right to buy or sell is held by the option buyer (or “holder”) and granted by the option seller (or “writer). To obtain this right, the option buyer pays the seller a sum of money called a “premium”. This money is paid upfront at inception. Traditional options are actually literally an “option” that the holder has, because he has the option to take possession of the underlying security (but is not obligated to). This does not happen with binary options. They are more like Contracts for Difference, where the trader is merely betting on the future direction of the price of the underlying.
A binary option is not a plain vanilla option. It is an exotic financial instrument that allows the trader to make a time/space bet on a security. The trader's bet has a time limit because binary options usually give the trader a wide range of time frames during which the bet will be active; the bet has also a space component because the price of the asset at the end of the time frame (the strike price) will decide the payoff of the option itself. There are binary call options, which are a bullish bet (you believe price will rise) and binary put options which are a bearish bet (you believe price will fall).
To make things clearer, here is an example:
Let's assume you feel YM is extremely likely to rally for the rest of the US morning after the cash open, but you don't know how much of a rally could take place. You decide to buy a (binary) call option on YM. Suppose the index is trading at 16500, so by buying a call option you're betting the price at expiry will simply be anywhere above 16500. Since binary options give the trader the flexibility to choose from many, many time frames - from minutes to months in the future - you choose an expiry date) that aligns with your analysis. You choose an option with a 16500 strike price that expires 2 hours from inception. The option pays you 80% if YM is above 16500 at expiry (2 hours from the start of the trade); if YM is below 16500 in 2 hours, you'll lose your investment, or get a minimum sum back (some brokers give you back 5-10% of your money even if you lose).
So the functioning of these “options” is really simple. You can invest almost any amount, although this will vary from broker to broker. Often there is a minimum such as $10 and a maximum such as $10000.
You allocate $100 to this trade. Let's say you were correct and YM at expiry (careful here: each broker decides how to calculate the last quoted price at expiry) was 16510. Therefore, you make a $80 profit (or 80% of $100) and get back the $100 you originally allocated to the bet. If the price had expired exactly on the strike price, you may have been entitled to getting your money back, but each broker may have different rules as it is an over-the-counter (OTC) market. Review that linked article on CFDs which talks a lot about counterparty risk. In this case, the broker is your counterparty so they are making the rules and the market you are trading on. Beware of this.
Considerations on Binary Option Mechanics
As you may have noticed, this article has been littered with the word “bet” and not “trade” or “investment”. That's because the research done for this article has left a decisive impression on me that these instruments are to be classified as a pure gamble. Let me explain more in detail.
It's true that like any normal trade, the risk and reward of a binary option bet are known. It does not matter how much the market moves in favor or against the trader. There are only two outcomes: win a fixed amount or lose a fixed amount. Also, there are generally no commissions. There is only one decision to make: is the security going up or down over the predetermined time horizon? There are also no liquidity concerns, because the trader never actually owns anything (similar to a CFD), and therefore OTC brokers can offer innumerable strike prices and expiration dates.
The evident difference between a trade and a binary option bet, is that the reward is always less than the risk. Your payout is never even 100% of the capital allocated. The broker always takes a haircut (which can vary amongst brokers). So the normal metrics we use in trading, like risk:reward, k-ratio, max drawdown, etc. are totally irrelevant. You need to be right over 60% of the time (depending on the payout the binary options broker gives you) to survive.
What is the “payout”? Payout is the profit you make if your bet is successful. For example: If the payout is 85%, and you invest $100 and win your trade, you’ll make $85 profit. If you lose, you lose all 100$. It is a permanent negative risk:reward ratio.
Another disadvantage is that the OTC markets (as of this writing) are unregulated, and there is little oversight in the case of a trade discrepancy. While brokers often use a large external source for their quotes, traders may still find themselves susceptible to fraud. This has actually been the case in numerous examples.
How Are Binary Options Priced?
The price of an option can be thought of as the probability of that event happening and is constantly shifting. It can fluctuate from anywhere between 0 and 100. Let's make an exaggerated example, to make things crystal clear. What do you think the probability of Crude Oil being above $500 tomorrow is?
Any guesses?
There is a 100% chance that the price of Crude Oil will NOT be over $500 tomorrow, so the option bid price will be close to $0 (as the probability of the occurrence is 0). And the option ask price will be $100 (because the probability of the occurrence NOT happening is close to 100%).
Now for a more realistic example: the current price of Crude Oil is about $101 per barrel, and you ask yourself whether by NY close the price will be over $101. In this case, the Bid and the Ask will be close to 50. Why? Because there is a 50% chance that Crude will be above $103 and there is a 50% chance that the price will not be above $103. If you think that the price of Crude will be above $103 then buy the binary call option and pay $50, if the price is above $103 then you will be paid back your broker's payout ratio.
How Do Binary Options Brokers Make Money?
Binary options brokers earn money in several legitimate ways. The most common way is through the difference between the payout rate and risk in a binary options trade. Binary options always involve a greater potential loss than a potential reward. It is in this discrepancy that binary options brokers profit. Some brokers also earn majorly on volume discounts. Some earn from the interest accrued in the funds deposited in their banks. Virtually all of the brokers are market makers so they also profit from the trader's losses.
The main profit center though, is definitely the payout ratio. Binary options brokers are able to make a near riskless profit by offering certain percentage payouts, and through active trading by clients. With a large number of clients we typically find that roughly 50% of traders believe an asset will rise and the other 50% believe it will fall. This may get skewed one way or another during a strong trend, but over the long-term this should average out to about 50/50 buying calls and puts. So with such an active market and traders taking both sides of the trade, the binary options broker is able to pocket a percentage of the action.
To keep things simple assume a binary options broker has 100 clients: 50 buy calls and 50 buy puts. When the option expires the winning 50 traders will receive an 80% payout in addition to their investment back. The losing 50 traders lose their investment. Now assume each trader placed $100 on the trade. 50*100 = $5000 which is how much the binary option broker receives from those on the wrong side of the trade. They then pay out winners: 50*80= $4000. The broker received $5000 but only had to pay out $4000, reaping a $1000 profit. In the real-world not all traders are going to bet the same amount, and it is unlikely to be perfectly divided (50/50) between call buyers and put buyers. This is why binary options brokers want lots of trading activity in lots of assets. The more traders they have, and the more options that are traded in multiple asset classes the closer they get to achieving the ideal scenario described above.
To sum up: binary options are definitely more of an online betting service than an actual trading venue. First and foremost, the payout ratio is always less than the initial amount invested, so the odds are already against the trader. Also, the SEC and the CFTC have issued warnings regarding Binary Options (https://www.sec.gov/investor/alerts/ia_binary.pdf and http://www.cftc.gov/PressRoom/PressReleases/fraudadv_binaryoptions ) and the brokers that offer them. There have been cases of fraud and shady practices. Generally speaking, trading on real financial instruments like FX, Futures, Stocks and Commodities is already hard enough, but you can gain an edge in many ways and actually make money by doing so. This is hardly the case with Binary Options. If you seek excitement, go to an amusement park. Don't waste your money on binary options.