Over the past few years, binary options trading has been widely marketed to retail investors as an alternative financial instrument/trading system to the more established choices of CFDs and Spread betting. Tellingly, in the UK and Europe binary options brokers are regulated by gambling commissions rather than financial services regulators such as the FCA in the UK or CySEC, the Cyprus Securities and Exchange Commission popular with pan-European brokers.
However, binary options trading tends to be marketed alongside and to the same target group as CFD trading and Spread betting. So what exactly is binary options trading, how does it differ to CFDs/Spread betting, why is it regulated differently and who is it suitable for? We’ll try to take an objective look at these questions here and hopefully leave those interested in exploring binary options trading with a clear understanding of what this kind of trading is and isn’t.
Let’s start by providing a brief definition of what CFDs, spread betting and binary options are and then looking at their common and differing qualities.
CFDs are an acronym of Contracts for Difference, which are a financial derivative. A financial derivative represents an underlying financial instrument and allows the holder to trade price movements of that instrument up and/or down without actually owning it. A CFD is a contract between two parties whereby the trader receives or pays the difference between the opening price of the underlying asset and its closing price at the expiry of the contract. There is a ‘unit’ however, the CFD, that the trader buys and sells. CFD trading can be, and usually is to at least some extent, leveraged, meaning that the return or loss on an investment is magnified from the total value of the actual contract.
CFDs are generally available on a huge range of financial instruments and markets, from individual stocks to indices, commodity prices and forex.
Spread betting is very similar to trading CFDs with a couple of technical differences. A spread bet is subtly different in that, technically, no ‘unit’ or asset of any kind is ever held by trader. It is essentially a ‘bet’, with a counterparty, the broker, taking the opposite side to the bet, on whether the price of a particular financial asset or market will move up or down.
As a result of the fact there is nothing ever technically owned by either party in a spread bet any profits are not subject to Capital Gains Tax, which makes spread betting popular in the UK, the only jurisdiction where this form of trading actually exists. However, the flip side of that advantage is the losses cannot be offset against profits for tax purposes as is the case with CFD trading. Another difference is that a spread bets tend to have a fixed timescale whereas CFDs are usually open ended.
Spread bets are recognised as an investment under the Financial Services and Markets Act 2000, which means they fall under the regulatory framework and jurisdiction of the FCA in the UK.
Binary options are also a mechanism whereby the buyer risks a sum of money on their correct choice of whether the price of a particular financial asset or market will move up or down. With a CFD or Spread Bet, the potential profit or loss is open ended and depends on by how much the price of the underlying asset traded on moves, and how much leverage the trader has applied to the trade.
Where binary options differ is that both the sum risked and the potential reward are predefined at the outset. In this regard binary options are closer to traditional betting in premise. There are only two outcomes available, hence the use of ‘binary’. A binary option has an expiry time which can be anything from seconds to several hours or a couple of days. Time periods offered tend not to be too long. The holder of the option will have bet that a financial asset will have either risen or dropped in price at the point the option expires. If, for example, £100 has been put down and the option holder has predicted the asset’s movement correctly, they will stand to win, say, £70. If they are wrong, they will lose £85 of the £100 put down. Like different bookmakers offering different odds, terms offered can vary between brokers for the same option but that is the general structure.
Like CFDs and Spread Betting, the eventual profit or loss of the holder of a binary options rests on their ability to correctly predict which way the price of a financial asset will move over a particular period of time. However, while in the case of CFDs or Spread Betting, the counterparty has no built-in statistical advantage, or ‘edge’, binary options brokers do. Normally the profit or loss figures on the option are set so that the trader has to predict the outcome correctly around 55% of the time to arrive at a neutral financial outcome. This is the underlying reason why binary options trading is regulated by gambling commissions rather than investment regulators.
Is Binary Options Suitable for You?
Despite the fact that binary options brokers have a statistical edge on their clients, there is nothing essentially wrong or ‘dodgy’ about binary options as long as traders fully understand what they are doing. It is very similar to sports betting. Players may feel they have the knowledge and skill to overturn the house’s statistical edge and win more than they lose. Some do manage and it’s fun. As long as binary options traders are fully aware of the nature of the game the fixed risk means it can be a great way to gain more experience of what impacts the movement of financial assets in a fun environment. The fact that there is money on the line allows them to do so in a competitive environment and to get used to controlling their emotions. This can be compared to the difference between playing poker for money or not: it does impact behavioural patterns when there is something at stake.
If you are new to financial markets and trading, trading binary options can be a very useful way to gain experience in a simplified, accessible format where potential losses are fixed and clear from the outset. This is an advantage of binary options which is perhaps generally understated and lost in the accusation that it is a form of gambling rather than investing, which, essentially, it is. Many binary options brokers also offer the option for very low stakes, which further minimises potential losses for learners.
As long as traders work with a reputable binary options broker they have researched, binary options can be a useful, risk-capped and accessible intro to financial markets for beginner traders. Or a bit of fun for more experienced traders. As with any financial commitment that carries an element of risk, you should never risk more than you can comfortably afford to lose. As long as traders stick to that principle, binary options can be a fun alternative or compliment to more traditional CFDs and Spread Betting.