If it’s heads you double your investment, if it’s tails you lose everything. That’s the essence of a binary option. Do you want to know what is trading in binary options. Many unscrupulous people are packaging these as investments. But it’s not an investment, it’s gambling! Why do we think binary options are gambling not investment? Okay, if you’ve been trading options for years it would make sense to play around with binary options, but for someone who’s new to investment it really is like juggling chainsaws. And thanks to a regulatory loophole companies that are selling binary options to unsophisticated investors are able to operate within the EU and don’t need a license from the FCA or from the Gambling Commission.
Why it is Gambling
To understand why this is gambling and not investment let’s step back and see what an option actually is. As its name suggests it’s an option, but not an obligation, to buy something or sell something (that would be a call option or a put option) for a fixed amount, that would be the notional amount at a fixed price, which is the strike at a fixed time in the future, that’s the expiry. Although that seems like a fairly simple setup the consequences can get a little bit hairy. But you don’t need all of that maths to understand the essence of an option. This is really all you need to know.
The case you’re probably familiar with is the one on the left where you just buy a stock. You buy it because you think the price is going to go up. And your profit goes up one for one and down one for one as the share price moves up and down. The upside of an equity is unlimited and the downside is that you could lose your whole investment. But the key thing here is the payoff is linear. If the share price goes up 1% the value of your investment goes up 1%. If the share price goes down 1% you’ll lose 1% on your investment. But what if you don’t want the downside? What if you just want to buy the upside of the stock at some point in the future? In that case you can buy a call option.
So let’s say the stock is trading at 100 pounds today, and in one month’s time you think it’s going to go up. You can buy a call option to buy the stock at 100 pounds. If in one month’s time the stock price is below 100 pounds you don’t exercise your call option. Remember it’s a right to buy not an obligation to buy at a hundred pounds. So if the price falls to 99 pounds you just won’t exercise the call option and you’ll lose what you paid for the call option upfront. But if the share price is 110 well, you would exercise the call option. You can buy it at 100 and you can sell it instantly for 110. And that way you make a healthy profit.
Profit Or Loss You Can Make
This is really neat because all of your losses are paid upfront. The most you can lose is the price of the option, and usually that’s a tiny fraction of buying the stock. That’s the beauty of an asymmetric payoff. But the aspect of it which is tricky to understand, particularly for people who are new to investment, is leverage. I’ve shown here two scenarios, one in which the share price moves up by 30% and one in which it moves down. If we buy the share we’d either make a 30% gain or a 30% loss. We’d pay a hundred pounds upfront and we’d either pocket 130 pounds or 70 pounds after that one year has passed. On the bottom you can see the cash flows, but this time it’s if we buy a call option.
The price we pay upfront is just a fraction of the hundred pounds, here I’ve shown it as 20 pounds. Now when the share price moves up by 30% we have an option to buy at 100. Do we do that? Well yes! We buy for 100 we sell in the market for 130 and we pocket that 30 pounds. But here’s the beauty. We only pay 20 pounds upfront so instead of a 30% return our return is boosted to 50%. So that’s the good side of leverage. Here’s the ugly side.
If the price had moved down by 30% well we certainly wouldn’t exercise our option in that case. Why pay 100 pounds for the stock if we can buy it in the market for 70? So the 20 pounds we pay for the option would expire worthless. Our return in this case would have been a loss of 100%. And the probability of that loss is fairly high, it would have been about 50%. If you compare the returns in those two scenarios for the share we’d have gained 30% for the option we’d have gained 50% and in the down scenario the share would have lost us 30% and the option would have lost us 100%. And that’s what leverage does. It amplifies our gains and our losses.
If you’re investing your life savings leverage should be used with a great deal of caution. So what’s a digital call option? Instead of the hockey-stick payoff that we saw before the payoff is now a step function which means that if the stock price moves above 100 we get the full payoff but no more. Our upside is no longer unlimited.