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Binary options in the U.S.: Not quite ready for prime time

Binary Options
Binary Options
Photo by Scott Olson/Getty Images

In our quest to understand trading options for income, the topic of this article covers a relatively new option product called binary options.

The basic definition of a binary option is simple: you are betting on whether an asset will be higher or lower than its current price by a certain time frame. If you are correct, you will receive a fixed percentage of the option's cost (along with the return of the cost); else, you will forfeit the cost. For example, the price of XYZ is currently $100. If you believe XYZ will be priced above $100 by the today's close, then you would purchase a Call binary option with that stipulation for $50. If you're right, you will receive $35; else lose the $50.

This is unlike the purchase of a conventional option in which the profit is determined by how far ITM (in the money) the underlying asset moves.

Binary options of all types and payouts have been available in Europe for some time; in the U.S., binary options were introduced relatively recently in 2008. Binary options in Europe are offered by individual brokers whose rules for determining payouts differ; it is NOT a regulated market. As such, only registered European brokers (with the SEC or Commodities Futures Trading Commission) can legally offer binary options to U.S. customers.

In 2008 the CBOE (Chicago Board Options Exchange), which is regulated by the SEC, started offering binary options to U.S. traders. We now also have NADEX, a U.S. exchange regulated by CFTC, offering binary options that can be sold prior to expiration (profit or loss determined by the probability of profit at the time of sale).

So, what are the pros and cons with binary options?

The advantages are...

First, a big advantage, and why many find binary options appealing, is the gain or loss is known; it is not a function of the difference between the underlying's price and the option's strike as with standard options. In fact, it is similar to a vertical spread, except you only need one option, not two (for a spread).

Second, the decision process is simple: is the asset going up or down? It is not a question of how large the move will (or must) be.

And third, there is no commission fee; just a small exchange fee.

The disadvantages are...

First, a big disadvantage is that the profit is less than the loss for a POP (probability of profit) of 50%. This is especially true for European brokers (which trade over-the-counter, OTC) . This means you will likely lose money, on average, since the odds are against you.

And second, the U.S. binary option market under NADEX (which allows buying and selling options prior to expiration) is illiquid. In other words, the volume and open interest of binary options are too low for efficient markets. If you try to sell prior to expiration, you are likely to experience significant slippage (just like standard options that are illiquid). Given the high expense for brokers to join NADEX (an open exchange), this is not likely to change in the near future.

In conclusion, before investing in binary options, you should: first, confirm the broker or trading platform has registered the product with the SEC (use EDGAR); second, check to see if the broker or trading platform is registered with the SEC (use the SEC's website); third, check if the broker or trading platform is a designated contract market (use the CFTC's website); and fourth, check the registration status and background of the broker or financial professional (use FINRA's BrokerCheck; National Futures Association's Background Affiliation Status Information Center, or BASIC).

Until more liquidity enters the NADEX exchange, binary options are not yet ready for prime time.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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