Common Misconceptions About Binary Options

Binary options are financial products that let traders make a yes or no prediction. They work very differently from traditional options, which is part of the reason there are many misconceptions about them. If you’re considering trading binary options, it’s crucial to understand how they work.

Key Takeaways

• Binary options are contracts that let traders make a yes/no prediction.
• Because of their volatility and seeming more akin to gambling, binary options are banned in the U.K., EU, India, and elsewhere in the world.
• Binary options have fixed expiration dates, so precise timing is required to succeed.
• These options can be risky, leaving you with nothing if you predict wrongly.

Introduction to Binary Options

A binary option is a financial contract that lets you make a prediction. Successful predictions earn a profit. In that sense, binary options work much like placing a bet on the outcome of a sporting event.

A trader chooses yes or no with binary options as the answer to a statement. For example, there may be a binary option for the statement “the S&P 500 will close above 5,200 on March 30.” If you put money on “yes,” you believe the index will close above 5,200 on that date. Someone trading “no,” thinks it will be at or below 5,200.

With binary options, successful trades pay $100, while losing trades end up with nothing. The prices of a binary option depend on the perceived likelihood of the event. Suppose it’s 10 a.m. on March 30, and the S&P opens at 5,400. The odds are so low that it would drop by 200 points. Hence, the “yes” position would trade close to $100, while the “no” option would trade close to $0. As such, the closer to expiry, the more the price will go toward $0 or $100. Earlier on, there might be volatility as traders make their bets on whether the outcome listed is likely.

Unlike other options, where risk or profit can be theoretically infinite, binary options have a fixed risk (the initial trade cost) and fixed profit potential ($100 minus the trade cost). That said, you can also end up with nothing, which is not something that typically occurs when trading other securities.

Four Myths of Binary Options Trading

Because binary options are different from other options and feel more like placing a bet than investing, there are many misconceptions about them.

Myth 1: Binary Options Trading is Illegal

One common myth surrounding binary options is that they are illegal. While this may be true in some jurisdictions, binary options are legal in the U.S. However, they can only be traded on regulated exchanges. In the U.S., there are three: Nadex, the Cboe, and the Chicago Mercantile Exchange (CME), which trades event futures that act just like binary options.

One reason for this misconception is that binary options are often linked to fraudulent activity. Scammers sometimes set up unregulated exchanges, taking investors’ money and refusing to allow withdrawals. Others have manipulated the results to produce losing trades. For this reason, regulators in the U.S. have spent much time over the last decade warning investors away from unregulated platforms.

Myth 2: Binary Options are Buy and Hold Contracts for Long-Term Investors

Another misconception about binary options is that they can be long-term investments like other securities, such as stocks and bonds.

In reality, these options are not suited for long-term investing. They all have a set expiration. At that time, traders will either lose their initial investment or receive a payout of $100. Investors can’t hold a binary option past its expiration date. Investors can also buy an offsetting position at some point before the expiration date to lock in gains or offset their losses.

The expiration makes timing very important when trading binary options. They’re used for short-term trading rather than long-term investments. Buying a binary option that is set to expire in the short term means that you can find out whether you were correct and, if so, redeploy that capital more quickly.

Myth 3: Binary Options Trading is a Fast Track to Immense Wealth

Binary options are popular for frauds because they’re very simple to understand. At their most basic, they’re like flipping a coin. Will an index his a certain number of points? Will the coin be heads or tails?

These fraudsters tout binary options’ simplicity and claim that they’re an easy way to quickly earn large amounts of money.

Binary options are highly risky. There are two outcomes when buying a binary option: receiving a $100 payout or losing all the money you spent on the option. A standard rule is to limit the risk of any individual trade to 2% of the capital available. By only risking 2% of your capital in each trade, a string of unsuccessful trades won’t cause you to lose all your money.

Myth 4: Trading with a Higher Percentage Increases Returns on Binary Options Trades

Some argue that limiting the amount you risk on any trade to only 2% limits your potential returns. However, the potential return is fixed when you trade a binary option.

If you buy a binary option for $20 and are correct, you’ll receive $100, a 500% gain. If you buy 10 options, paying $200, you’ll receive $1,000, which is still a 500% gain.

Risking a higher percentage of your capital allows you to invest a larger dollar amount and receive a larger payout, but it won’t increase your returns in percentage terms. Successful binary options trading relies on accurate prediction and analysis rather than taking significant risks and investing a large percentage of your capital.

What Are Options?

Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time frame. They are used for hedging, speculation, or to generate income.

How Do Binary Options Differ From Traditional Options for Payouts?

Binary options have a payout that is either a fixed amount or nothing at all. Thus, while traditional options have returns that depend on the underlying asset’s price, binary options provide a predetermined, set payout if the option expires in the money.

What Should I Consider When Choosing a Binary Options Broker?

While Nadex allows you to trade directly with them, the Cboe and CME require you to work with authorized brokers. When selecting a binary options broker, consider the trading platform’s user-friendliness, the availability of educational resources, the quality of customer support, the transparency of the terms and conditions, and the security measures in place to protect client funds and personal information. If a brokerage suggests great riches are just over the horizon or is spamming you to trade constantly, find a broker who can better serve your needs as an investor, not a gambler.

How Can I Tell If a Binary Options Site Is Legitimate?

Binary options trading is regulated in the U.S., but there are many scams and illegitimate sites, most from off-shore. An excellent way to check is to use the Commodity Futures Trading Commission’s Registration Deficient List to see if the site you’re using is listed as fraudulent or illegitimate. But we can save you time: unless they are named Nadex, the Cboe, or the CME, they are not authorized to offer binary trades in the U.S. and aren’t to be trusted.

The Bottom Line

Binary options give investors the opportunity to profit from a successful yes/no prediction. Because they differ from traditional options and are targets for online fraud, many misconceptions surround how they work.

Though you may have heard that binary options can be a quick path to easy wealth, that is far from the case. To succeed with binary options, you need to analyze each trade carefully and manage your risk carefully.

Read the original article on Investopedia.