Binary options are rapidly gaining in popularity. They are something of a tweaked option that are touted as superior to investing in stocks, granting investors limited downside risk regardless of how much the market falls.
But the firms that offer them never compare them to the instruments that binary options are originally derived from – regular options. And the reason why they are rarely if ever compared to regular options is because they simply pale in comparison. Putting a binary option alongside a regular option reveals just how faulty binary options really are.
So let’s do that now to learn a couple of important disadvantages to binary options that their vendors simply will not tell you. But first, let’s identify what binary options are.
Anatomy of a Binary Option
While variations have begun entering the marketplace after some 4 or 5 years of their introduction, the basic structure of a binary option is deceivingly simple.
1. Select the instrument you want to trade (gold, the Euro, the S&P 500 index, etc.), select the time frame until the trade expires (a month, a week, a day, an hour, even a minute, with many more durations in between), and select the direction in which you believe that instrument will move – either up (call option) or down (put option).
The amount of the move does not matter. All that is needed to win is to correctly guess if the instruments will be higher or lower at the time of expiration than it is at the time you place your trade. Some firms also allow you to pick certain price targets, known as “strike prices” as in conventional options. Doing so can decrease your loss and profit potential, or increase your loss and profit potential.
2. After selecting your instrument, the duration to expiration, and the direction of movement, the standard investment (it’s really more like a “bet”), is $100, which you pay upfront.
3. When your option expires, a win will reimburse your original $100 bet plus pay a $70 profit, while a loss will consume your $100 bet and return nothing. Some options are available which can pay more than the standard 70% return, paying as much as 90% or “up to” 100%. However, none will ever pay more than 100%; this is an important note to remember.
There are other pricing scales that measure the “probability” of a win and charge you according to how close the market is to a win. For example: if the bet is that the S&P 500 index will end the current trading day higher than yesterday’s close, and it is currently 9:00 am eastern time before the market opens, the bet would be fairly close to 50% of the payout minus a little spread which is kept by the firm as their fee. But if you are placing the bet at 3:45 pm when the S&P 500 is already up 10 points over yesterday’s close, then a call option would likely cost some 90% of the payout to properly reflect the increased certainty of a win, while a put would likely cost some 10% of the payout to properly reflect the decreased probability of a win.
However, most binary options have a fixed cost and payout, where the payout is never greater than the cost you are risking. The standard is: $100 risked, $70 won.
Sounds easy enough. But is it a good deal? Not if you compare it to regular options, which is why you will rarely hear a “broker” (really just a “bookie”) ever compare them to options. Instead, they will generally compare binary options to stocks.
Their biggest selling point? Stocks can lose more and more money as the market falls, whereas binary options cap your losses regardless of how much the market falls.
So let’s do what they don’t; let’s compare binary options to regular options and see what exactly they aren’t explaining to us.
Binary Options’ Atrocious Risk-Reward Ratio
With both binary options and regular options, your loss is capped. You pay your premium up front when you buy, and if the market moves against you, your option simply expires worthless; you lose only the amount you spent at the beginning, not a penny more.
So far there is no difference between binary options and regular options when you lose. The difference exists when you win.
In the case of binary options, your winnings are generally between 70% and 90% of your bet. If you bet $100 and win, you will be awarded your original $100 back plus between $70 and $90. However, these winnings are capped just like your potential losses are. Regardless of how much your instruments moves, your winnings never increase.
In the case of regular options, your winnings do increase as your instrument’s movement increases. For instance, a call option on a typical stock will increase your winnings by $100 for every $1 the stock continues to move in your favor. If it wins by $2, you win $200; if it wins by $5, you win $500. The more your instrument wins, the more you win.
Hence, the risk-reward ratio you get from binary options pales in comparison to the risk-reward ratio you get from regular options. Where binary options offer a limited risk and even more limited reward, regular options offer limited risk with unlimited reward. Just on that one comparison alone you would be generating more profit from regular options than you ever could with binary options over time.
Why? Because just to break-even with binary options that payout 90% of your bets, you would need to win 10 times out of every 19 bets (10 wins = +$900; 9 losses = -$900), or 52.63% of the time. With payouts of 70% you would need to win 10 times out of every 17 bets (10 wins = +$700; 7 losses = -$700), or 58.82% of the time.
Can you do that? Win more often than you lose? Perhaps for a short streak you can. But can you do that consistently over time? Hardly.
You Don’t Have to Sacrifice Profit Potential
Even if you could win more than 52% or even 58% of the time, you would still be better off with normal options. Why? Because many of those wins would earn you more than the 70% to 90% paid by binary options. In fact, professional options traders rely on regular options’ unlimited upside potential to help them recoup their losses and still make a profit even when they win less than 50% of the time.
While the limited downside risk that options offer may be the first feature that attracts traders in the first place, it is the unlimited upside profit potential that keeps them coming back to options again and again, and keeps them in the game at all. Without that unlimited profit potential you really don’t stand a chance trading options, as traders will rarely win more often than they lose.
So if you can’t win more times, you need to win more profit in order to make-up for those losing streaks. Don’t be loured into binary options on the limited loss factor, for along with that limited loss comes limited profit.
For the same amount of money, regular options will also limit your loss, but will give you unlimited profit potential on top of that. Just 2 or 3 extended winnings can be more than enough to cover some 8 to 10 losses and still leave you with some winnings left over – something you will never get from binary options.