I was fortunate to have parents who schooled me on the lessons of investing from a young age, so I thought deepening my knowledge by writing about binary options could have some potentially valuable benefits (and yeah, it definitely did). I am by no means a broker and possess no formal training, but after researching binary options and having a surprisingly short chat with Mom and Pops, I came to the very obvious conclusion that legitimizing trading signals for binary options is impossible. The options, and the signals, are nothing more than gambling… but they sure seem way less fun than poker. If you’re interested in binary options, at least let me educate you on the reality of what they are, how they work and how these so called ‘investment platforms’ turn a profit. If your parents skipped over these lessons, learn how to invest from a pro.
Binary options are sometimes referred to as “all or nothing” options for the following reason: the payoff is either a fixed amount (it can also be an asset) or nothing at all. There can only be two results, thus the name “binary.” The options are easy to understand, which further heightens their appeal to DIY investors. Knowledge of stocks’ movements and magnitudes is not required. All you need is a hunch.
The fulcrum of binary options is their timeframe. You are betting against the clock; this can be 30 seconds or the close of trading. Ultimately, they are European-style options, meaning they are cash-settled (who doesn’t like the sound of that?) and cannot be exercised prior to the expiration date.
Let’s take a closer look at the payout structure. Binary options can be bought in both directions, meaning you can buy a Call (or “Up”) option, or a Put (or “Down”) option. In other words, you can bet on stocks to rise or fall (there’s more to it than that, but that’s the general idea). The payout, of course, is relative to the risk; the bigger the risk, the bigger reward, just like in most types of gambling (I suppose getting lucky at the slots would be an exception).
Let’s look at an example. Mental math is crucial for DIY investing, so even if you opt out of binaries like a smart investor, it would still be wise to learn the secrets of quick math. Imagine company XXX is trading at $10 a share as of 12:00 p.m. with a binary payout of $20. If, at the future maturity date (say, 1:00 p.m.), the stock is trading at or above $10 (meaning you would have finished in the money), then you receive $20 (a 100% profit). But if the stock is trading below $10 at 1:00 p.m., then you finish out of the money, and you lose everything (a 100% loss).
When a Loss isn’t a Loss
Sometimes you do not lose everything, but even in these cases the majority of the investment is lost. You might invest $100, finish out of the money, and receive $20 back (80% loss). This is where binary option platforms employ rhetoric to make this sound not only less terrible, but actually ideal. The popular phrase is “controlled risk to reward ratio.” Like I said earlier, the payout is pre-determined, so platforms use this to their advantage by saying the amount you can lose is predetermined and thus limited. By contrast, they say, traditional options are not defined and therefore the losses can be infinite. While technically true, the possibility of, say, Google stock crashing 80% in one second is unthinkable. It’s best not to think of pre-determined payouts in numbers, i.e. “Hey, I can only lose eighty bucks.” Think of it in terms of percentages: “I can lose 80%.” Because most people aren’t going to make one trade; they’re going to make hundreds, thousands, and with a consistently steep risk, it’s easy for them to quickly be in over their heads.
Maybe You Want to Listen to Forbes?
Gordon Pape of Forbes wrote what is probably the most quoted article (on the internet, at least) on the subject of binary options. The fifteenth paragraph pretty much sums it up:
No one, no matter how knowledgeable, can consistently predict what a stock or commodity will do within a short time frame. Will Apple (APPL) shares go up or down in the next 10 minutes? Unless there has just been some major announcement from the company, there is no way to even guess at that.
And, just to complement Mr. Pape’s opinion, here is a highlighted except from the U.S. Securities and Exchange Commission’s official investor alert on binary options:
Much of the binary options market operates through Internet-based trading platforms that are not necessarily complying with applicable U.S. regulatory requirements and may be engaging in illegal activity.
Of course, illegal activity abounds when it comes to the stock market and the government, so there’s definitely some hypocrisy involved. But our last item of interest concerns these Internet platforms. Your average stockbroker collects a percentage of your investments every year; a generous broker might only collect 1%, but the average is closer to 3-5%, and hedge fund managers are famous for collecting 20% or more. Of course, if they lose you money, they in turn lose money, not to mention your business (in which case they lose everything). So there’s some incentive there. But these binary options platforms operate like casinos; they don’t lose if you lose; they win. They are in effect “the house,” and in the long run, the house always wins.
One of these “fairer” websites offers $64 for every successful trade you make of $100. If you lose, you get back $22. That doesn’t look like such a bad spread. But let’s assume 50/50 odds over the course of 1,000 bets; you win 500, you lose 500. Your winnings are going to be $32,000, and your losses are going to be $39,000. That’s if you guess right half the time, but as Gordon Pape notes, “there is no way to even guess…” Just to break even you would have to guess right 55% of the time, which would put your winnings at $35,200 and your losses at $35,100. Do the math. This is gambling, my friends. Some people get lucky, and some people can make a living playing poker, but the vast majority of gamblers only manage to make the owners of casinos some of the richest people in the world. So don’t be a sucker. Attain financial security the smart way.