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Binary Options: Living Up to the Hype

If you use the web for financial and investment information you have probably seen some astounding advertisements promising astronomical short term investment opportunities. Some of the more recent claims are "up to 95% profit in one easy trade," "Earn up to 85% per trade," or "Win up to 88% per trade." Are these types of claims accurate? Does the world of binary options live up to the hype? We will explore this question in this report.

What is a binary option? Perhaps it is best to define the word 'option' first. An option is simply a financial contract where we agree to buy or sell some sort of asset at a certain price within a certain time frame. Options fall into the derivatives category because such a contract has a value without actually holding the underlying asset itself. For example, if you own an option contract for Apple or Google, that contract has value all by itself, despite the fact that you own no shares in the company. The mere fact that you have a contract to buy or sell shares in the future has a value in and of itself. Option contracts expire at some time in the future - minutes, hours, weeks, months or even years, depending upon the particulars of the contract. Upon expiration, an option contract becomes worthless. So those who invest in options must do something with them, buy or sell, sometime before they expire.

A binary option is a highly specialized option contract which cannot be sold after purchase. This type of option is simply held by the purchaser until it expires with a predetermined profit or loss. The advertisements that describe a 90% profit simply describe an option deal whereby a 90% profit (or loss) would be generated if the underlying asset performs in the manner that you predict. For example, let's say the Dow Jones Industrial Average opens up at 16,501. You think it will close higher by the market close. So you decide to purchase a $500 call (upward price expectation) option with an end of day expiration. The day grinds to a close with the Dow closing up one point at 16,502. Your option contract appreciates in value by 90%. Thus, your $500 appreciates to $950. If the DOW closes down, you lose the contract and will lose most of your $500. Some brokers will give you back 15% on losses. But this type of option is binary in nature, meaning you will either win or lose at the time of expiration. Some have described this type of option like throwing money on red or black at a casino. This is a fair description. Yet most option investors would like to believe they are much more skilled than gamblers who play the casinos.

Binary options have been around for years as private over-the-counter deals. These exotic options were first introduced to the general public in 2008, when the brokers started offering the deals online. Today there are dozens of brokers who specialize in these exotic options. Most of these are located offshore in places like Cyprus and the British Virgin Islands.

Are binary options legal? Like most legal subject areas, the answer is not simple. Most of the binary options brokers operate in locations outside of the jurisdiction of securities regulators. Some of them operate under casino gaming licenses. There is now a CySEC (Cyprus Security and Exchange Commission) which is attempting to regulate the industry for those brokers within that jurisdiction. In the United States there is a relatively new broker called NADEX (North American Derivative Exchange). This firm is fully regulated by the Commodities and Futures Trading Commission, a US government agency similar to the Securities and Exchange Commission. Binary option investing is so new that it will take some time to see how the regulatory environment actually pans out. Certainly it is fair to say that the legal trend is toward fully regulated firms which offer exotic option investment opportunities to eager clients within any jurisdiction.

Before we look at the upside of binary options let's take a look at the downside. Exotic option investing is not traditional investing. Some say it is very similar to gambling. I like the red/black roulette wheel analogy. When you acquire a binary option contract it will either win or lose at some point in time, depending upon the expiration time of the deal. Many of the option brokers now promote 60 second contracts. A fair assessment would be to call such a contract an investment/gambling hybrid. In fact, it could be argued that any Wall Street investment is really nothing more than an elaborate gambling scheme.

Unlike traditional option deals, where each contract controls a certain number of shares, there is no leverage with binary options. With this type of option you cannot exercise the options. Thus you have no right to the underlying asset. The option is strictly used to generate income for the holder.

There is no liquidity with binary options. There is no marketplace to sell these unexpired contracts. Once you purchase the contract you are in for the duration. Some brokerage firms are starting to experiment with liquidity, offering to either buy back certain of the contracts under certain conditions or find buyers willing to take over unexpired contracts. It will be interesting to see how the industry evolves in terms of such an after-market.

Another downside for binary options has to do with the losses. To truly make money in the long run you have to be a skilled investor with high win to loss ratio. Because when you lose with these options, you lose really big, upwards of 90%. Some brokers are now returning 5% to 15% on the losses. This is probably just a marketing ploy to get you to stick with them. But depending upon the size of your account and the size of your trades it could help with another trade.

Unfortunately the mainstream financial press doesn't have much to say about the field of binary contracts. Dr. Jon Najarian, a host of the CNBC television program "Fast Money," calls binaries "training wheels" for getting involved in traditional options. Najarian says that binary options will have wide appeal to "individual investors, hedge funds and institutions, who have an opinion, one way or another, on future price movements." An article entitled "Don't Gamble on Binary Options" appeared in Forbes magazine in 2010. Gordon Pope, the author, spent two pages convincing the readers to stay away from binary options. He closes the article out by stating that "If people want to gamble that is their choice. But let's not confuse that with investing. Binary options are a crapshoot, plain and simple." It is unfortunate that Pope places binary options in such a negative light. He fails to mention that virtually all types of investments are a crapshoot.

Now we will discuss some of the pros of binary options trading. First of all, these options are an excellent and simple way to get exposure to various markets - stocks, commodities, Forex and the like. Binary options truly make it possible for anyone to trade markets. Some of the brokers will even open accounts with $100 and let you experiment with $10 deals. Again, this paves the way for almost anyone to get involved.

Trading binary options is an excellent way to test various trading strategies without risking large amounts of money. This type of option account can be opened up in minutes and does not require long questionnaires, approval and cumbersome procedures like with a conventional options account. Most of the brokers accept credit cards as well as your favorite online payment method. Wire transfers with your bank are also available. Because most of these option firms are located offshore, opening up an account in one of these locations is a simple way to set up funds offshore.

The most obvious benefit of investing in binary options is the huge upside potential. Where else can you get returns of +80% in such a short period of time? So, do binary options live up to the hype? The answer to that question depends upon how they are used and how successful a particular binary option investor is. Of course the underlying market conditions also play a large role in whether how binary options signals work  a particular binary option contract is profitable or not. The bottom line is that binary options can be a very profitable investment vehicle for short term profits.