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December 12, 2015

Beware of Binary Option Contracts

Companies are very aware of our tendency, as humans, to overestimate the odds of making money. They use this to their advantage by pitching products and services as money-making opportunities that in reality are highly effective tools for separating us from our money.
One bad idea for a financial product brought to my attention in recent months is binary option contracts. These are securities whose final price is solely determined by whether stock indexes, commodities, currencies and bitcoin close above or below a certain level. 
There also event-driven contracts such as whether the weekly jobless claims and nonfarm payrolls will be equal to, more than or less than a prespecified amount. The option contracts are binary because they settle at either $0 or $100. Provider Nadex gives an example: “Will the price of gold be above $1700 at 1:30pm?” You buy the contract if you think the answer is yes and sell the contract if you think the answer is no. At the end of the day, the week, or a specified time, you either make a profit or lose everything you spent (which can vary between $0 and $100 per contract).
Technically, this is a form of investing. Describing it as a form of speculating is more accurate. And there is a very thin line (though often a legal one) between speculating and gambling.
You won’t easily find language warning of you of the dangers. At the very bottom of Nadex’s website is a sentence written in a small font that reads, “But please remember these are volatile instruments and there is a high risk of losing your initial investment on each individual transaction.”
So why would an individual investor buy a binary option? Entertainment is one reason. Overconfidence is the more probable reason. Products like these are pitched in way to make them sound enticing. Among the benefits touted by Nadex are, “Limited Risk—The maximum amount you can lose on every trade is your original investment” and “Low Collateral Required—Binary contracts are priced between $0 and $100.” It all sounds enticing until you notice that your account balance is significantly smaller than when you started.
Based on the research, there is reason to believe that most individuals who buy and sell binary options see their balances decrease. Terry Odean told me that a 2010 study he conducted, along with three other researchers, found that only 1% of day traders made money after costs through their skill. He added, “the vast, vast majority of day traders were losing money.” A 2012 Wall Street Journal article found that more than 70% of accounts at currency broker FXCM were “unprofitable for those trading them.” A survey conducted earlier this year of fantasy sports websites FanDuel and DraftKings by Eilers Research estimated that 70% of participants were not making money. The research firm added that the actual results might be worse because “it’s human nature to round higher when it comes to investing or wagering and in reality most players are doing worse than they imagine.”
Even when profits were made, investors fared worse by trading. A 2013 analysis conducted by SigFig for Reuters found that individual investors who traded options saw their portfolios underperform those who didn’t by 45%.
If the numbers aren’t enough to convince you that speculating with binary options (and speculating on financial securities in general) is a bad idea, consider who you are completing against: professionals with more data, better analytical tools and faster technology. When you, the individual investor, try to speculate with financial securities from your home computer, your smartphone or tablet, you are essentially showing up to a racetrack with a Toyota Corolla while everyone else has Formula One cars with professional drivers sitting behind the steering wheel.
Are there exceptions? Sure. In a large enough sample, there will be those who make money. Once the influence of luck is factored in, however, the percentage of people who make money through skill will prove to be very small. Since success at investing comes in part by simply following the long-term odds, why waste time on a very risky product like binary options? You’ll be wealthier if you don’t.
The Week Ahead
Nine members of the S&P 500 will report earnings next week: FedEx Corp. (FDX) and Oracle Corp. (ORCL) on Wednesday; Accenture plc (ACN), General Mills (GIS) and Red Hat (RHT) on Thursday; and CarMax (KMX), Carnival Corp. (CCL), Darden Restaurants (DRI) and Lennar Corp. (LEN) on Friday.
The Federal Open Market Committee will hold its final meeting of the year starting on Tuesday. The statement and committee forecasts will be released at 2:00 p.m. ET on Wednesday. Chair Janet Yellen will hold a press conference at 2:30 p.m. (The Fed last raised its federal funds target rate on June 29, 2006.) Richmond President Jeffrey Lacker will speak later in the week, on Friday.
Elsewhere on the economic calendar, the November Consumer Price Index (CPI), the December Empire State manufacturing survey and the December housing market index will be released on Tuesday. Wednesday will feature November housing starts, November industrial production and capacity utilization and the December PMI manufacturing index flash. The December Philadelphia Federal Reserve manufacturing survey will be released on Thursday.
Friday will be a quadruple witching day, with both option and futures contracts expiring.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle

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