At The Money Principle we seem to be specialising in achieving impossible targets! Our regular readers will know that, having paid off a large amount of debt, we are now aiming to build wealth – some £2.5million worth – over quite a short time – 5 years. There is no way that investing the thousand pounds or so every month liberated by having no negative wealth to repay will achieve this target*. It is pie in the sky. We need to look at less conventional ways of building wealth and many, including property, investing in businesses and options trading, are being researched and will be discussed, tied and tested on our upcoming website. Today, as a taster, I decided to tell you about binary options trading. Let’s start with something simple: what is an option? And what the heck is a binary option when it is out?
Consider an ‘asset’ such as oil, gold, a Euro, shares in Barclays Bank or the NasDaq index. Some of these are ‘real’ such as oil but all have a price that varies every minute. Traders buy or sell the asset and for each purchase or sale, a price will need to be agreed with the other party – the person selling or buying the asset. This is invisible to the general public but it is what goes on 24/7 on trading floors around the world. The result is that each trade – purchase or sale – goes to establishing the price of the asset. In the case of a currency, you need to be purchasing it using another currency – the price of a dollar is a dollar!
Speed is therefore imperative with trades being completed in less than 100 microseconds! Yes, microseconds (one millionth of a second), which is why traders spend such a lot of money investing in the highest speed computers, software and links!
It is also imperative that there are sufficient trades to be able to establish the true price of an asset. The more trades there are, the smaller will be the difference between the purchase and sale price – the spread – and the more precise will be the amount someone is prepared to pay for or sell an asset. This may not be a perfect system but it works and it is the best way of establishing a value that has been found to date.
So far, everything is about the here and now – the instant a trade is made. But frequently you need to work in the future – your company has made a large sale or purchase in another currency. Just how much is that worth in your own currency? You want to know how much wheat will cost next summer. Of course you cannot afford to wait that long – you need to know so you can budget. You book a summer holiday but again you want to pay for it now – or at least know how much it will cost.
Suppose you made a sale in Euros but then it turns out that the Euro goes south drastically just before you deliver – or worse, after delivery but before your customer is due to pay you. This is a large risk and could bankrupt your company so you take out some insurance against that happening. Fortunately the financial markets have thought of this and enable you to ‘hedge’ the price – for a sum. But it may be that the price moves in your favour so you may in the end not want to cash the insurance in. We are entering the world of options.
The market for ‘hedging’ – derivatives, options and so on – has got a bad name after the financial crash. Politicians and journalists have jumped up and down, generally showing that they haven’t got a clue how markets work but wrecking havoc all the same. Derivatives and options are entirely legitimate tools and essential for the smooth operation of any trade these days.
Rather than try to explain this in detail, the Daily Telegraph has a useful guide about options in the currency markets or you can try the omni-present Wikipedia instead for details on a wider variety of assets.
So where does this leave us? In a market, we can regard the outcome as something uncertain, just like the weather or a sporting event. Whenever such things occur, someone will start gambling about it! That’s life! So rather than actually trade yourself, you can bet on the outcome. Binary options trading is just that, conducted over short term such as an hour or by the end of the trading day. The reason they are called ‘binary’ is that there are only two outcomes – win or lose. It is not like spread betting where the amount you win or lose could be very large.
All you do is choose an asset – an index, a commodity, a share price etc. – and use your judgement as to whether it will reach a certain value or not by the end of the period. The platform will choose the value or use the current value and offer you a profit margin such as 70% of your stake (plus of course your stake) but rather than leave you empty-handed should you be wrong, it may return a small amount of the stake such as 15%.
The price is taken from one of the main sources such as Reuters. Suppose you want to bet on the Euro-dollar that it goes below the current value published. If you think it will go down below the value, you buy a ‘Put’, if you think it will go above the value, you buy a ‘Call’. Then sit, wait, chew your nails, kick the cat or whatever. This profit or return on investment (should it succeed) can be over a few hours only so the annualised ROI can be enormous if you keep winning!
But if you stake all your winnings on a subsequent bet and it doesn’t come off, you have reduced your account by a factor of 6.67! So to keep ahead of the game, you need to ensure that you win at least 4 times as many times as you lose. Once you have a big enough pot, therefore split it and don’t put your entire shirt on the next horse. Read the confessions of a gamber!
It is important to realise that with binary options trading, your investment has no direct relationship with the underlying ‘asset’ or indeed with standard options on the asset. It is purely a bet and the platform will have its own way of calculating what the odds are just as standard betting platforms will give different estimates as to whether Manchester United will win the English Premiership this season (all pretty certain at the moment but remember last year?).
There you have it – binary options explained. It sounds complicated but, as with most things, it comes down to simple ideas just with complex or unfamiliar vocabulary. May sound risky but it can also be fun; we may give it a whirl when the time comes! Maria, though stays out of it.
*[Saving £2000 a month at 2% interest, after 5 years we will have all of £126,094.71p. At 10% interest, it would be £154,874.14. To achieve the £2.5 million, we would need to be saving £10k a month at 50% interest! Possible but not probable.]