Binary options are seen by new traders as an easy way to get started without any knowledge of the markets, industry, data and the tools and financial analysis methods that seasoned traders depend on.But the thing that makes it simple also makes it risky, or at least riskier. As any regulated broker with past record will tell you, this is more luck than investment strategy. But in order to understand the risks, you have to first know how binary options work.
What Are Binary Options?
A binary option is an option in which you get a fixed amount as a payoff in case the option expires in the money, or you get nothing if it expires out of the money. Since there are only two possible and very specific outcomes, it is called a binary option.
The payoff may be in the form of cash or the value of the underlying asset, so you have a cash-or-nothing option and an asset-or-nothing option as the two possible types of binary options.
It’s simple enough, and all you have to do is place a put or call option on one of these two types. The key problem is that there is no regulated market for this kind of option, and therein lies the key risk, among several others.
Risks of Binary Options – Lack of Regulation
There are plenty of platforms and apps that allow traders to buy, sell and trade binary options. Most work as stated, and traders will gain or suffer losses based on the acumen and knowledge on binary options and the use of the platform.
However, the lack of regulation means that a lot of the trading is done directly, and may be susceptible to fraud or unethical practices on the part of some traders. The SEC and CFTC have already issued a binary options fraud warning to investors about the dangers of trading in unregulated binary options.
Risks of Binary Options – Lack of Liquidity
Another problem is that you don’t own the underlying assets when you invest in binary options. This means the option is automatically exercised, and you are not able to buy or sell the asset itself.
This would be a deal-breaker for many a regulated broker who knows how critical it is to exit trades at the right time. However, binary options don’t allow you that freedom, and this means there is a certain lack of liquidity that may handicap you as an investor.
Risks of Binary Options – Fixed Profits
This is not exactly a risk, but it would be considered as one of the disadvantages if you look at it as an investor seeking maximum returns. Since the payoff is fixed (or nothing), you can’t really benefit from a market event like a share market or commodity investor does. Regardless of how big a market event is and how much other investors gain, you will get only your fixed payoff, and that’s only when you’re right.
In short, you need to stick to regulated markets and a reputed binary options platform. Don’t overextend your positions, and be satisfied making fixed amounts of profits buying, selling and trading binary options.