What are Binary Options?
A financial exotic option where the buyers either receive a payout or lose their investment is termed as a binary option. Under a binary option, the buyer predicts the outcome from two possible results. It is called binary because it offers only two choices – Yes or No. The buyer receives the agreed payout with the correct prediction and loses otherwise. He receives a payout if the option expires in-the-money and incurs a loss if it expires out of the money. So, a binary option provides clear outcomes on every trade.
Working of Binary Options
Each binary option trade begins with a simple question – Whether or not underlying asset’s price will be below or above the strike price at a certain point in the future? Taking an example, suppose a trader anticipates that the price of XYZ share will be above $10 on 2nd July 2019 at 1:00 PM, and bet $100 on it. Now, if the share price of XYZ crossed $10 at that time, the binary broker credits the agreed payout (a certain percentage of $100) in the trader’s account. But, if the price stays below $10, the trader will lose the investment.
The binary options available on U.S. exchanges differ from those traded in the rest of the world. In the US, a feasible alternative when hedging or speculating is offered only when the trader completely understands the two opposing and potential outcomes. Understanding with an example, suppose a trader has to decide on whether or not the gold price will be more than $1300 at 10:30 AM today? If the trader thinks it will, he will buy the option, and if the answer is no, he will sell the option.
Risks Associated with Binary Options
The straightforwardness of the binary option attracts investors, but such option comes with a defined risk. The binary broker discloses the risks associated with the underlying financial product when the trade is first established. However, in a binary option, the trader can never lose more than the amount paid and enters in each trade, knowing the maximum potential reward.
Let us have a look at the risks associated with the binary options:
- Risk of Losing the Entire Bet: As the binary options are all-or-nothing propositions, the trader loses the entire bet in case the prediction is wrong.
- Required to be Held Until Expiration: The traders have to wait until the expiry date of the option as the binary option cannot be exercised at will. So, binary options are found to be illiquid.
- No Unlimited Upside Potential: With these investments, there is no unlimited upside potential as the losses and gains connected to the binary options are capped.
- Non-Regulated: Binary options that are traded outside the US are not regulated by any exhange. However, in the US, they are legal and available to trade on a Commodity Futures Trading Commission’s regulated US exchange ‘Nadex’.
How to Limit Binary Options Risks
As the binary options are an attractive form of investment due to the high returns, it is necessary to know about the risk management strategies to limit or control the associated risks
Take a look at a few of the risk management techniques:
- Choose a Right Broker: The first and foremost point to note is to choose the correct broker that would help in managing the risk effectively. The traders should select a broker based on their risk appetite and should choose only reliable brokers.
- Avoid Scams: With the growth of the binary options, the scammers have also grown in the financial market. It is essential that the traders should learn a way to spot scammers and fake regulatory agencies.
- Avoid Using Large Trade Sizes: In a greed to earn higher returns, the trader should not trade in large sizes. The trading in binary options in easy but it is also challenging, risky and not that every person can master. At any given point of time, traders should not expose more than 5 per cent of the account size to the market.
- Follow Money Management Rules: In order to earn a profit, the traders should follow the money management rules. It is recommended to keep the risk per trading ratio at 2 per cent. The risk per trading ratio of 2 per cent means that the trader is not risking more than 2 per cent of the funds in a single trade.
Regulation of Binary Brokers in Australia
In Australia, the binary options brokers are governed by ASIC wherein it has framed strict rules for binary options brokers who desire to connect with Australian clients. Before joining the industry, every legitimate broker is required to obtain an AFSL (Australian Financial Services License) from ASIC. Also, the broker has to meet a very high standard of financial integrity and capability to get a license from ASIC.
According to ASIC, the binary options trading is legal in Australia, provided that the broker offering the services should be ASIC’s member. So, the Australian traders should sign up with the brokers that are registered and regulated by ASIC. It is more evident that the ASIC regulated brokers would ensure transparency and fairness as there is a regulatory agency keeping an eye on them.
As a financial regulator, ASIC looks after the interests of the investors and retail traders. However, ASIC has clearly mentioned in the detailed guide for binary options trading that ‘binary options are high-risk instruments that are not suitable for all investors.’
ASIC’s Regulated Binary Brokers
Some of the binary options brokers that are regulated by ASIC are HighLow, CLM Forex, GFT Australia, Binarycent, Binarymate and Finrally.
Let us have a look at the key features of these brokers below:
ASIC Tough on Binary Brokers
In a report released in June 2018, the ASIC raised concerns over the retail OTC derivatives sector that failed to meet ASIC’s expectations. In a review of 57 retail derivative issuers conducted by ASIC, it was found that nine issuers offer binary options and up to 80 per cent of binary options clients were unprofitable. The report mentioned that among the products offered to retail investors by OTC derivatives issuers, binary options generally offer the least transparency.
Besides this, ASIC identified the following misleading practices in the retail OTC derivatives sector:
- Inadequate risk management practices
- Misleading marketing materials
- Inadequate monitoring of counterparties
- Unclear pricing methodologies
- Inappropriate referral arrangements
The regulator informed that it will continue to take action to address these issues by improving issuers’ compliance and raising industry standards.
After being granted additional powers by the federal government, the Australian Securities and Investments Commission is expected to ban its first toxic financial product in August. The additional power will enable ASIC to ban individual products or entire classes of products. The products that are likely to be targeted by the regulator are contracts for difference, binary options and some forms of junk insurance.
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