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Why you should avoid trading binary options

Updated on December 20, 2014

It's a game?

Do not be mistaken to think binary options are a financial instrument. It may be one day, but, for now, it is nothing more than a financial casino where the house will most likely win - either straight-up or by scamming clients. In either case, the lack of regulatory transparency just makes the conditions too unfavorable. Keep in mind that I am not saying binary options is pure gambling, I'm only saying that there are too many issues with the current market preventing it from being a financial instrument.

What are binary options?

Options are pretty complex instruments in comparison with equities. However, binary options are much more straight forward. The word "binary" suggests two, but two what? It simply means that there are two trade options. With binary options, you can either place a "call" or a "put". You place a "call" if you believe the price will go up in value and you place a "put" if you believe the price will go down in value.

However, we also need a sense of time. Do you believe the price will go up in the next three weeks? Months? Years? The time is known as the expiry. If you believe the price will go up over the next three weeks, then the expiry time is just three weeks from today. Let's bring this into a binary options broker context.

The broker will set the instruments and the expiry times. The instrument is whatever you are trying to speculate the appreciation or depreciation. Usually, the instruments are currency, commodities, and stocks. Brokers will list currency pairs such as EURUSD, commodities such as gold or silver prices, and stocks such as Apple (NASD:AAPL). Also, the expiry times are set by the broker as well. Technically, the broker can set any expiry times in days or weeks, but they typically set it to 60 seconds. We will explore why they do this in a little bit.

A Quick Lesson on Risk versus Reward

There's often a saying that goes like "high risk, high reward". Logically, this makes sense. However, what does this really mean in investment terms? Let's take an example from a coin flip betting example because it illustrates binary options trading quite nicely.

Coin Flip Betting

Details
Payout A
Payout B
Win (Heads)
$10
$15
Lose (Tails)
$10
$20

Suppose you and your friends decide to bet on a coin toss. You can go with either payout A or payout B. Payout A offers $10 for every time you win or the coin you flipped lands on heads. If you lose, you pay up $10. On the other hand, payout B gives you $15 for each win and $20 for each loss. Which strategy would you go for?

Although Payout B offers $5 more per win, chances are you will go with Payout A. This is because you are factoring in the potential loss per bet. With Payout A, you only risk $10. If you lose on the first attempt, you can still break even on the second bet you make. With Payout B, you need to win twice if you lose once because a win of $15 will not cover a loss of $20.

You can now see the issue at hand with binary options. Binary option brokers always follow the "Payout B" model. You will never see a broker offering 100% or more than 100% payout. The value will always be less than 100%.

A Typical Binary Options Platform

Notice that the payouts are consolidated in the 70% range. This means that for every dollar you bet, you will only win 70% of that or just 70 cents. This is the first instance where the odds are tipped against you. The word "binary" means two. With binary options, you are betting on either the price going up or the price going down. In other words, you are picking one of the two possible choices. The probability of the price going up is 50% as this is one of the two possibilities.

The Analysis Argument

As a trader in a different market, I understand that some will argue it is possible to tip the favor of winning to greater than 50%. The idea is what if you are able to accurately predict where the price is heading in the future? There is a key thing to keep in mind here.

Your other trading experience may not be transferable to binary options trading. The payout percentage is not the only way brokers tip the odds against you. Many traders ignore the time frame disadvantage. Almost all trading instruments do not have a time or expiration date. This means that when two people buy an investment, they may hold it for different periods of time and so their profitability will differ. Yes, it is important to cut your losses short and let your profits run. However, many lessons out there will emphasize the importance of giving leeway to your losers. This means that you need to give enough space and time to let that loser turn into a winning trade. Unfortunately, time is not on your side with binary options. These bets expire in 60 seconds, which makes performing analysis even more difficult. Furthermore, traders usually set price targets rather than time based targets. This is because price targets are more predictable than time based targets, which is another way the odds are tipped against you.

This is best illustrated with an example so I pulled up a couple of charts from my own trading software for you to visualize how the price moves in a minute. Imagine you make a bet at the left red line and you have to hold onto that bet until the right red line. Would you have succeeded?

EURUSD Currency Instrument

This is a popular currency instrument offered by most binary options broker. The next image is also another very popular currency instrument that will be offered as well.

USDJPY Currency Instrument

AAPL: Apple Stock Price

Equities (stocks) are also commonly offered by binary options broker. While Apple is financially strong and its shares will most likely go up in value in the future, the short term price fluctuation was quite unstable. If you made a bet that Apple's stock price will increase in the next 60 seconds, you may have started to have your doubts within the next 5 seconds. Perhaps you decided to make a bigger bet that the stock price will decrease in order to make back your losses, but then the price closed higher. Here you can see how, once again, binary options brokers can tip the odds in their favor.

Quick Question

Is it possible to consistently and accurately predict future price directions in a 60 second time frame?

See results

There really is no correct answer to the poll question above. Before you start thinking to yourself that you are an exception, start paper trading. Record the start time and price and then the end time and price. If the price ended lower and you predicted a decrease, then you are off to a good start. In order to be statistically accurate, you have to repeat this process over and over again. In the long run, you need to win over 60% of the time. This may sound easy, but I assure you it is not. Professional hedge fund managers get the market right 40% of the time and they have more information than you do.

Other Concerns With Binary Options Brokers

There are a couple of other concerns that surround binary options brokers. Regulation is a key factor that makes binary options so dangerous. Currently, there is no regulation. Brokers can offer these services without obtaining a license with their local securities commission. No regulation means there really is no oversight that these brokers are operating fairly. Of course, I am not saying all binary options brokers are a scam. However, lack of regulation should be a warning sign. If you had to choose between regulated and unregulated meat, chances are you will go with the regulated meat. The same analogy applies.

Another concern with these brokers is price feeds. When instruments such as currency pairs are offered, you do not really know which price feed the broker is using. The foreign exchange market is very decentralized and often times the price feeds for the same security will differ among various providers. Having a price tick off means the difference between a win and a loss. While there is no way to know if brokers are engaged in this activity, brokers can theoretically swap or change price feeds to produce a tick off from you're in the money position. This is theoretical, but brokers can definitely do this if they choose to.

The BinaryOptionsWire Incident

Gordon Pape, an author at Forbes, made a post about the dangers of binary options. For some reason, BinaryOptionsWire found the need to respond three years later with a counter argument shooting down Gordon. I, of course, will be siding with Gordon because BinaryOptionsWire chose to use arguments that have not been proven and is still up for debate. I found several issues with their arguments. Keep in mind that Gordon's arguments do not concern me. I am not one to judge his points as they were presented in the form of an interview. However, I have found that we have raised similar points such as regulation, which BinaryOptionsWire failed to address.

1. "Finally the writer is also erroneous in his claims that binary brokers are operating in a completely unregulated environment. This may have been true several years ago but with the first binary options license having been awarded late in 2012 and a slew of other companies rushing to also engage with the regulatory procedure by the time you read this there is a good chance that many other binary brokers will be operating in fully licensed environments."

The author failed to back up their 2012 claim. If the first binary options license was awarded in late 2012, what is the name of this broker? Furthermore, what is this slew of other companies rushing to become registered dealers? To date, only Nadex is regulated by the CFTC. Speaking of the CFTC, they charged Banc de Binary for being an unregistered futures commission merchant. This took place on June 6, 2013 and can be found the details can be found in the CFTC PR6602-13 filing.

2. "Now as for the “house” having a slight advantage due to the payout structure, which the writer states as being around a 54% success rate being needed for a trader to break even. This is significantly less that online Forex due to the fact that there are no spreads in binary options, and the precalculated payout structures (again unlike online Forex) are upfront and leave no possible room for miscommunication between parties."

This begs the question as to what is the success rate of online Forex trading? Also, is it accurate to compare the payout structure of binary options against those of the foreign exchange market? Keep in mind that binary options brokers offer instruments beyond just currency pairs. Popular stocks are also offered so is it not important to also compare the success rate to returns from the equities market? I mentioned that traders must have a 60% win rate while institutional traders only have a 40% win rate. These statistics were gotten from one of Anton Kreil's lecture on how retail traders are a left at a disadvantage when faced up against institutional traders. For those who do not know Anton Kreil, he is an ex-Goldman Sachs trader and now a portfolio manager and running Institute of Trading. If anyone has the experience and the right to state this statistic, he does.

3. " Binary options have become so popular recently because inexperienced traders can quickly become proficient at trading them. The growth of the industry testifies to this fact far more than it does to brokerages using aggressive sales tactics."

Retail Forex brokers and dealers must publish profitability reports as part of the regulatory requirements of the National Futures Association (NFA). ForexMagnates summarizes these quarterly releases quite nicely. At the time this article was written, the 2013 Q4 report was the latest to be released. Interactive Brokers had highest percent profit accounts at 45.3%. This means that the majority of traders are still losers. Although this is the Forex market, BinaryOptionsWire does not have the right to make the claim that inexperienced traders can quickly become proficient at trading them. Unless binary options brokers publish profitability reports, we will never know if the majority of their clients are profitable. Nevertheless, think about it this way. If the majority of your clients are profitable, would you not want to show it off in hopes to gain more clients? Clearly, binary options brokers are not confident enough to the point of publishing profitability reports. Another reason why they are not publishing these reports is because there are no regulatory agencies demanding them. This, once again, questions their claim that brokers are seeking regulatory licenses.

4. "The outcome of a dice roll has absolutely nothing to do with all the previous rolls of that dice. In trading the price action of an asset is intimately connected with its historical price action. This means that attempting to forecast a random walk is an exercise in futility, and using the historical movements of an asset’s price in combination with the wider geopolitical events currently affecting it, are both statistically significant methods of being able to forecast with some degree of accuracy what is likely to happen next."

I think the author really likes run-on sentences, but more to the point. The author does not seem to grasp the random walk theory. As the author stated, the outcome of one direct roll does not influence the outcome of future rolls. It is not possible to outright state that the random walk theory does not apply to the financial markets. It ignores the premise that random walk theorists believe the market is efficient and there is no way to beat it. Currently, academics have yet to be able to disprove this theory so the ability to predict future price movements based on historical movements is much up for debate. Even if this is possible, I already posted three charts showing the difficulty of predicting the price movements on such low time frame. Price fluctuations become much less predictable in the time frame offered by binary options brokers. Recall this is one of the ways brokers seek to gain an edge.

In Conclusion

I hope that body of text did not bore you, but I hope it clarified some concerns you may have. I strongly recommend avoiding binary options trading. If you really want to dabble in this market, go with a financial betting site. Online betting and gambling sites are regulated by the gambling commission. These offer greater consumer protection. No site is perfect so only risk what you can afford to lose.

*This article does not promote binary options trading nor financial gambling. Please trade at your own risk.

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      jagg1973 2 months ago

      Nice reading! thanks for sharing