Binary Options: Investing or Gambling Tools?
Binary options have a simple premise. Something will or will not be true at a specific point in time. Traders can take either side of the bet. The potential return is known before the trade is made.
When trading -- stock, options, commodities, etc., we invest (either long or short) in an asset that has value. Sure, we earn money when we are correct in our projection and we lose when wrong. It's pretty simple. But few traders think of what they do as gambling. After all, we buy assets with real value. When we by stock, we are following the advice offered in the prudent man rule.
When making a typical investment, we do not know the reward potential. The sky's the limit. There are two exceptions
- Option spreads come with both limited gains and limited losses.
- Binary options. Option buyers win or lose. In other words, the winning trade returns a pre-determined sum while a losing trade returns zero (100% loss).
We try to trade with an edge.
- Chart-reading provides information for traders using technical analysis.
- Studying economic data aids those who believe in fundamental analysis.
- Value traders look for unloved, under-priced stocks.
- Option traders prefer to buy undervalued options.
- A trained meteorologist may be able to benefit from forecasting weather by deducing an abundant harvest.
Whatever it is, when we think that we know something, we believe we have an edge. Thus, traders do not consider their actions to fall under the gambling umbrella.
To some extent we are fooling ourselves. We may think we have an edge, but do we really? The majority of professional money managers (mutual fund managers, pension fund managers) fail to beat the market averages on a consistent basis. These are professional traders. They are hired, and well paid, to outperform their benchmark averages. But most of the time, the majority under-performs. Thus, I side with those who tell investors that trying to pick your own stocks is futile. In other words, investing is somewhat of a gamble.
I also believe that we can use options to improve our chances of being successful traders. But that does not mean buying or selling options in an attempt to predict direction. It does mean using spreads to reduce risk and enhance returns. For example, instead of buying 100 shares of stock, the average trader would do better to sell puts (one at-the-money put option). This strategy wins more often than stock buying, although it does come with a limit on profits. We each have our own preferences, but if we manage risk carefully, I prefer to win more often, rather than going after large wins.
To me, the increased chances of earning a profit make it feel much more like investing and much less like gambling.
Trading binary options is different. It is gambling. Sure the bet may be on a short-term stock market move, but it is no different from betting on a horse race with only two horses running, or who will a football game or an election. The probability of success is ~50%. That allows traders to bet on either outcome: The market will be above (or below) the specified price at the specified time. 'Traders' buy these binary options, but they cannot be sold before the final outcome is known.
For example, if the DJIA is trading at 18,500 at 2:00 PM, there will be a binary option that pays off when the market ends the day above that price level. And another that pays off when the market ends below 18,500. These are essentially 50/50 propositions.
But the payoff is not good for the gambler. The reward for winning is less than the cost of losing.
The cost of each option tends to average $55 and the reward is near $50. However, there are many binary-trading sties and each is different. To come out ahead, you must win more than 55% of the time. The odds are stacked against the binary option trader.
It's a big industry with many players. Please be warned that trading binaries is not investing.