Binary is an apt adjective for this type of option. In programming parlance binary used to describe either of two states. 1 or 0. In the sports betting industry binary options are also popular – win or lose. In other words, there are only two possible outcomes. There is some basis to this all or nothing description of binary options trading. Here’s a short explanation of how it goes.
Take the price of any asset at any point in time. You make an intelligent guess on whether this price will increase or decrease over a specific period of time and bet $100 that you guessed right. If you are you win back your bet and plus a pre-agreed amount. If you’re wrong you lose almost all of your $100.
Of course it’s not as simple as that. In fact, there’s serious math behind binary options and people who engage in binary options trading, like all others involved in financial markets, are pretty confident that their numbers are better. Because in a single binary option trade, the outcome for the participants is also binary. One loses, one wins.
How do binary options brokers make their money?
When you buy an option, you must buy it from someone, which will be your counterparty. Binary options are just bets on the outcome of the market movement on a predetermined timeframe. This means that when you buy a binary option from your broker, you actually bet against the broker. If your option is a winner, the broker will credit your account with the payout, and when the option ends ‘out of the money’ the broker will win the bet. It works in the same way as betting on sports against a bookmaker, only that in binary options you bet on financial assets, not on sporting events.
So, the broker makes money when you lose. This means that the broker must make sure it wins more than it loses, just like bookmakers do. How does the broker achieve this? Binary trading brokers will always have a lower payout compared to the price of the option, if we’re talking about simple Call and Put options which have a 50% chance of success. Let’s think about an option with an 80% payout and a 5% insurance for out of the money trades. If you buy such option 100 times at the price of $100 and you win 50% of the time, your payout will be the following: 50 x 180 + 50 x 5 = $9,250. However, the price you paid for the options was 100 x 100 = $10,000. This means that in the end you will lose $750 and the broker will make a profit of $750 even if your win rate was 50%.
But aren’t financial markets predictable? Isn’t it easy to have a high win ratio in binary options and beat the broker? Well, my answer would be that financial markets are not as predictable as many people think, especially in the short term. Also, most people trading binary options have no clue about what they are actually doing and they are just randomly betting on the market to see what the outcome is. In this case they end up with an average win rate of around 50%, exactly what the brokers wish.
Binary options brokers use two tricks to make sure they make more money than what they pay back to their clients:
1) They advertise in a way that encourages beginners to signup in order to make sure the majority of their clients are just novices who gamble on the markets. Such clients are trading mostly for the thrill of staking real money and they may trade again and again even if they lose some money, because just as in sports betting, sometimes they will win and will be happy about it.
2) They promote short term options such as ‘60 seconds options’ and other options with deadlines shorter than one hour. It is well known among experienced traders that only sophisticated trading algorithms can predict such short term movements with some success, and even such algorithms cannot have a sufficiently high win rate in order to beat the broker’s advantage caused by the lower payouts. Also, binary brokers have very simplistic platforms that do not allow the use of real trading robots, so any trading done on very short term options will have an average success rate of 50%.
Since most binary traders will just gamble with a 50% success rate, binary options brokers will be profitable against the majority of their clients, just like bookmakers are profitable against the majority of bettors.
Of course, there are also traders that are profitable and make money trading binary options, but they are just as few as the people making money from sports betting, and are a negligible proportion among the total number of traders. Brokers can just accept the loses on those clients because they make much more money on those who lose on a regular basis.
You may conclude that binary options brokers are just scams since they make money when the client loses, but this is a totally wrong assumption. Technically speaking, binary brokers are just market makers providing a pool of options that traders can buy. This is how most derivatives brokers work, and this includes many forex brokers and also CFD (Contract For Difference) providers. They can be regulated by financial institutions and as long as they conduct their business in a honest way they are legitimate businesses.