A unique form of investment option, binary options have recently come under scrutiny by the Financial Industry Regulatory Authority (FINRA) for potential increased risk of fraud. The potential for fraud does not mean binary options are unsuitable for everyone, but investors should be aware of all their advantages and disadvantages. Developing an understanding of all investment opportunities prior to investing can minimize the risk of fraud and help investors make fully informed decisions.
What are Binary Options?
Binary options are so-called because upon the expiry of a specified period of time, the option either makes a pre-determined amount of money or nothing at all (meaning the investment is lost). They provide investment access to stocks, indices, commodities, and foreign exchange. The most common type of binary option is called a “high-low” option (also called a “fixed-return” option).
Under high-low options, if the trader is correct in predicting the direction of the market and the price at the time of the expiry is on the “right” side of the strike price, the trader is paid the specified fixed return. This is true regardless of how much the instrument actually moved. If the trader is incorrect on predicting the direction of the market, the investment is lost.
To be more specific, if a trader believes that the market is rising (or that it will), a “call” is purchased. In order to make money, the price must be above the strike price at the time of the expiry of the option. Alternatively, if the trader believes that the market is falling (or that it will), he or she would purchase a “put.” In order to make money, the price must be below the strike price at the time of expiry. The trader is either “betting” that the future price at expiration will be higher or lower than the current price.
Advantages and Disadvantages
One of the greatest advantages of binary options is that the risk and reward are known up front, before the purchase is made. Further, it does not matter how much the market actually moves; the trader only needs to be on the “right” side of the strike price at expiry to make money. This means that a trader can be correct on the market direction by a very small margin and still succeed on the investment. Another advantage is purchasing binary options are very simple as they only involve one decision: will the underlying asset increase or decrease in value?
The major disadvantage of binary options is that the trader must be correct a fairly high percentage of the time in order to make money. This is because the rate of return is fixed. For example, a trader purchases an option thinking the underlying asset will increase in value, which it does. It does not matter how far above the strike price the underlying asset increased to in terms of the rate of return enjoyed by the trader. This means that there is no possibility of one large successful option purchase offsetting a number of unsuccessful purchases that result in losses.
If you would like more information about legal issues related to investments, contact an experienced securities law attorney today. At the Silver Law Group, we help investors pursue recovery from stockbrokers and other investment professionals who have committed misconduct.
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