You may have heard the term binary option before. This term may have a negative connotation for you or perhaps it has a very favorable one. Or, maybe it elicits no feelings what-so-ever. The truth is, there is a great deal of confusion surrounding binary options. They can be a fantastic trading instrument as long as they are structured correctly and traded on a regulated exchange.
This article is going to explore exchange traded binary options and how they differ from those typically offered off-exchange or OTC, often by firms outside of the U.S.
While all binary option contracts share the same name, there are many different flavors available. As a rule, all binary options share one characteristic. That is, at expiration there are only two potential outcomes, all or nothing. Hence the term binary option. For many of the instruments sharing this name though, that is where the similarities start and end.
If on hearing the term binary option, you had a negative feeling, it is likely you had heard of, or perhaps even traded binary options as offered, by unregulated, or very lightly regulated, off-shore firms. Over the last several years, the number of said firms significantly increased offering “an easy way to get massive returns from a small investment”. This is truly a case of if it sounds too good to be true, it is.
As a result of the activities and conduct of said offshore firms, in June of 2013, the CFTC and SEC issued a joint fraud advisory alerting investors to the number of complaints they had received. Thankfully in this advisory they also explained to investors what to look for in legitimate firms offering binary options. Unfortunately, much of the confusion continues to this day.
The full release of the CFTC Advisory can be found here: CFTC Fraud Advisory on Binary Options
In the CFTC Fraud Advisory note, Nadex (North American Derivatives Exchange) was listed alongside the CME as one of three exchanges to legally list binary options in the US and that any other entities outside of the three mentioned, who were offering binary options that are commodity transactions, are doing so illegally.
Ultimately, binary options are a very serious trading vehicle which allow traders, or those interested in trading, a means to participate across a range of markets, while having absolute control over their risk exposure. It is important though for individuals interested in participating to understand what to look for in a firm, why to look for it and what the benefits of doing your homework are.
Below is a short list of the benefits of trading binary options on a U.S. Regulated Exchange.
U.S. Exchanges are regulated by government agencies dedicated to protecting traders and investors. As part of this protection, they hold the exchanges to extremely high standards in every area of their operation. Two of the agencies responsible for maintaining a fair marketplace are the SEC which has oversight of a securities exchange like the CBOE and the CFTC which has oversight of Nadex.
Safety of Funds-
As part of the regulatory structure, exchanges that hold member funds, have strict requirements as to how this money may be handled. This generally means that funds are held in segregated accounts with top-tier financial institutions. Additionally, when members wish to withdraw funds, the exchanges must provide an easy to understand and fast withdrawal process.
One of the main benefits of trading binary options on exchange is that the markets are transparent. Because the pricing of these contracts is derived from and settled against a 3rd party market, traders have complete price discovery and transparency. Also, if a trader has a question regarding a settlement, the exchange will provide time and sales data for verification.
Unbiased Marketplace –
An exchange’s most basic function is to match buyers and sellers in an unbiased manor. To maintain a bias free environment, the exchange itself, nor its employees may take positions in its markets. Also, unlike some OTC firms which may take the other side of your trade, exchanges do not make prices or take the other side of your trade. You are never “betting against the house”.
Set Rules –
If you ever played a game with an older sibling in which as soon as you started doing well, they changed the rules to put you back at a disadvantage, you probably understand the importance of having clear, well defined rules that cannot be changed mid-stream. And how much more important is that when your money is on the line? As part of the governance, exchanges must publish publicly well established, clearly defined rules. Any rules that do change need to be approved by the regulatory authority and members must be notified of the rule change prior to it taking effect. Not so with some of the offshore firms.
There are many different uses for binary options and I would encourage anyone interested in exploring them to do so. As with trading any instrument though, you need to understand not just the contract and corresponding risks, but know the firm with which you are trading.
To learn more about exchange traded binary options, visit Nadex.com
Futures, options and swaps trading involves risk and may not be appropriate for all investors.