March 7, 2016 | Binary Options Brokers
Most people familiar with binary options only know about trading with a regular binary options broker. This means the broker offers a wide range of options that traders can buy. It doesn't matter if it is a call or a put option, the process is the same: the trader buys the option from the broker. Whenever the trader wins, the broker loses, and whenever the trader loses, the broker wins. This binary options trading model has two problems:
1) There is a conflict of interest between the trader and the broker since the broker makes money only when the trader loses, and the broker loses money when the trader is successful.
2) Since the broker wants to make money, the options will have low payouts in order to give the broker an edge over the trader. This is why payouts are never more than 85% when it comes to simple Up/Down options that have a 50% win rate for the majority of traders.
Considering the two issues described above, it is no wonder that most people trading binary options end up losing money on the long run. Of course, there are successful traders as well that make money trading binary options, but the losing traders far outnumber the winning ones, as the low payouts offered by the brokers require a very high winning rate to be profitable. If the option payout is 85%, a trader needs to have a winning rate of approximately 54% to break even, and most brokers have payouts lower than 85%.
Figure 1: Binary options brokers make money when traders lose
However, there is another model of binary options trading that very few people know about which offers better odds (higher payouts) and does not create a conflict of interest between the trader and the broker. It is called trading on a binary options exchange.
A binary options exchange is a trading environment where traders can buy options from other traders, or write their own options and wait for other traders to buy them. It is a peer-to-peer type of trading where you don’t trade against a broker, but against other traders like you. This is very similar to trading options or futures in a stock exchange where you buy contracts from other market participants, not from your broker. When trading on a binary options exchange, your broker is not your counterparty as it only acts as a trading environment and not as a market maker.
So how exactly does a binary options exchange work? Who creates the options and why is it better than trading with a regular broker? What if there is no liquidity on the exchange?
Figure 2: Binary options exchanges make money from commissions
In order to have enough liquidity at any time, the binary options exchange will allow some partner brokers to write their own options and list them on the exchange. There will be minimum requirements in terms of payout (for example a minimum 85% payout) in order to guarantee that liquidity providers offer options at least as good as regular binary options brokers. The liquidity providers are more than happy to list their options on the exchange because a payout of 85% means the liquidity providers will be profitable in the long run. This guarantees that there will always be liquidity available and traders can buy options at any time.
But the best part is not the liquidity provided by the partner brokers, but the options created by traders themselves, and the ability to create options yourself as a trader. Traders can write their own options, which means they can create options and sell them on the exchange. In order to attract buyers for their options, they need to offer better payouts than the liquidity providers, since the exchange will list the options with the highest payouts at the top. This creates competition between option providers and results in options with higher payouts.
A trader may decide to write options with a payout of 95% in order to be competitive. This means that his options will be more attractive than the 85% options offered by the liquidity providers or options with 90% payout offered by other brokers. This competition reduces the profit margin of option writers and offers better odds for options buyers. When the payout is higher there is a more equal playing field when both option writers and option buyers have their fair chances to be profitable.
A binary options exchange offers the unique possibility for traders to write options and act like a binary options broker by selling them to other traders. This means that a trader can turn into a liquidity provider listing his own options with the payout he is willing to offer. A higher payout will increase the chances of the options to find buyers but will reduce the edge the option writer has against the option buyer.
The advantage of writing options is the advantage of having the odds in your favor. Assuming a 50% probability of winning and losing, the option writer should be profitable in the long run because he can offer a payout lower than 100%. The binary options exchange will charge a small commission (like 2%) from the winning options, which means that an option with 95% payout is still profitable in the long run since the option writer offers $95 when the buyer wins and receives $98 when the buyer loses for an option priced at $100.
Since an option writer can be profitable even when offering high payouts, he is incentivized to offer competitive payouts in order to increase the number of options he sells. The higher the turnover (the number of options sold), the higher the chance for the statistical odds to reflect themselves in the end result. If you sell only 10 options there is a greater risk of losing more than 50% of them if you are unlucky or if the buyer was a skilled trader, but if you sell 500 options the number of wins and loses will be much closer to 50%.
Buy options with higher payouts and don’t fear your broker
If you prefer to remain an options buyer, it is still better to trade on a binary options exchange. There are two major advantages compared to a regular binary options broker:
1) You will get better payouts because of the competition among option writers.
2) You no longer have to fear that your broker may influence the price feed against you since the broker is not your counterparty anymore. The price feed will be provided by the exchange which doesn't take sides since it charges the same commission no matter who wins.
A binary options exchange is the ideal place to trade binary options even if you prefer to remain a buyer only, as you will have the comfort that you’re not trading against your broker and the market is not stacked against you.
The exchange model is a very new approach to mainstream binary options. Classical options exchanges such as the Chicago Board Options Exchange are not very accessible to regular traders because of the complicated contracts they sell and the high requirements. This is why retail providers of binary options chose the broker model, since it was easier to build and very profitable. Hundreds of binary options brokers flooded the market trying to attract clients, but none of them offered something different because the broker model was the easy way to do it.
Unfortunately for traders, none of the binary options brokers has created an exchange so far, although there were some failed attempts. We hope that as the binary options market matures, exchanges will be given a chance and become the new norm in trading.
Exchange-traded binary options would be the best way to trade binary options, but they are still not available for retail investors. We believe the industry will shift towards the exchange model in the following years as more and more traders will become aware of this superior trading model and this will create the demand for this new approach.
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