Last week I received an email advertising the benefits of binary options. Although I’ve taken finance courses in university, we never discussed binary options, so I did some further research. Binary options have really taken in recent years with new binary option websites appearing every day. Binary options are popular because of their simplicity of trading. However, before you plunk your life savings into binary options, there are some important risks you should be aware of.

What are Binary Options?

Binary options are a type of option where you, the trader, takes a yes or no position on the price of an underlying asset, such as a stock. Commonly referred to as digital options or all-or-nothing options, if the option settles in-the-money, you receive an agreed-upon dollar amount; however, if the option settles out-of-the-money, you receive a lesser amount or in some cases nothing. This makes binary options attractive because there is a known upside and downside; this makes them simpler to trade than traditional options.

For example, let’s say you purchase a binary cash-or-nothing call option on ABC Corp’s stock struck at $50 with a potential  payoff of $500. If at the maturity date, the stock is trading at or above $50 you receive $500; otherwise you receive nothing and you lose your $50.

What are the Advantages of Binary Options?

The main advantage of binary options is that risk and reward are known ahead of time. Despite how much the price of ABC Corp’s stock moves up or down, there are only two outcomes: you either win a fixed amount or lose your investment. Unlike other forms of trading, there are no fees or commissions. Furthermore, you don’t have to worry about liquidity, because you never actually own the stock. Lastly, you can access markets worldwide and trade 24/7.

What are the Downsides of Binary Options?

Binary options may appear to be simple, but are anything but. Binary options are not a zero-sum game. The house has a slight advantage and always wins in the end. To come out ahead, you have to be right 54.5% of the time.  Option websites wouldn’t be in business if there wasn’t the opportunity to make a profit.

Binary options have often been compared to gambling. If fund managers are only able to beat the markets 10% of the time over the long-run, what makes you think you can do any better? “Past performance is no guarantee of future results” is a mantra in the world of investing. It’s hard enough to predict the movement of individual stocks over the long-term, let alone in the short-run. Many binary option websites ask you to predict if a stock will go up or down in only five minutes.

The Bottom Line

It’s important to be aware of the risks before buying binary options. Binary options can easily become as addicting as gambling. Although you may come out ahead at the beginning, chances are the house will win in the end.

Have you ever traded binary options? Is it fair to compare them to gambling?

Sean Cooper is the bestselling author of the book, Burn Your Mortgage: The Simple, Powerful Path to Financial Freedom for Canadians, available now on Amazon and at Chapters, Indigo and major bookstores, and as an Audiobook on Amazon, Audible and iTunes.