Many new traders ask how do binary options brokers make money? If this is you and you want to know what incentivises the companies behind this rapidly expanding business then be sure to tread on.
It is well know that one of the advantages often given for trading with binary options is that you don’t pay any dealing charges to the broker.
Although digital options providers are referred to as ‘brokers’ they don’t’ in fact ‘broker’ a deal in the traditional sense of the term.
Rather than offering brokerage services to match up deals between two interested parties, the Binary Options broker deals with the trading client directly.
This is termed ‘over the counter’ (OTC) dealing. Contracts are sold directly by the issuer (the broker) to the buyer (the trader).
It’s All About Balance
The principal way in which brokers make money comes from the design of the trading platform itself. It you look at the returns offered by a broker you will find that the pricing is skewered in the favor of the broker from the outset.
The return paid by the broker makes an assumption that an equal number of traders will win as will lose. This is of course a theoretical assumption. It does however provide a simple illustration on which the binary options model operates.
Let’s assume two traders each purchase a contract on an asset. The first one buys a $100 Call option expecting the price to go up, while the second trader purchases a $100 Put contract expecting the price to go down. The broker offers a return of 70% for both contracts.
At the conclusion of the contract the broker has to make a payout based on the fact that only one of these contracts will finish in the money. Let’s do the figures.
The broker has received
$200 ($100 x 2 for each traders contract)
and must payout
Winning Trader – $170 ($100 stake returned + $70 profit)
Losing Trader – $0
This leaves the broker with a net $30 profit from the transactions from the contract.
This is of course is a very simplified version of the way in which this works. However the potential for the broker to make big bucks can be seen if you scale this up. Think of many thousands of dollars being placed on each contract when dealing with the leading binary options brokers each day.
The flaw in this trading model is that it naturally assumes an equal weighting on both sides of a binary options contract. A broker won’t make money and can quickly run into trouble if this equation becomes too skewed.
Brokers ultimately have to balance the books. This platform model will of course generally balance itself over time. A broker with a sufficiently large client base is also more likely to be able to operate closer to the 50:50 model.
Brokers can of course adjust pricing returns and rebates on contracts to pull their operations back into line from time to time if needed. Their operations are also stabilised by charging for fees for withdrawal.
However an inexperienced broker losing out heavily on a particular contract or suffering a poor run over a number of contracts could quickly find themselves with liquidity issues. This can lead to periods of lower returns, delays in processing withdrawals or ultimately could even lead to bankruptcy if the broker is unable to meet its obligations.
The inevitable charge that brokers have stood accused of is price fixing. There are many claims around the web accusing brokers of manipulating pricing and trading against their clients. This is often cited as an underhand way in used to that binary options brokers can make a profit.
Technically this is possible. Brokers normally add a line to their disclaimers highlighting that they are only providing indicative pricing on their contracts which is based upon option supply and demand. This is of course often interpreted as carte blanch to price their contracts differently to actual market rates.
However in reality such practices would not be good business. Given the number of brokers now on the market and the competition for clients, such behaviour could rapidly bring down a company. It seems that most pricing complaints arise when trading shorter term contracts.
Forex and spread betting companies suffer similar accusations. However these complaints levelled at brokers are difficult to substantiate and more probably the result of differences in charting price feeds. In particular very short term contracts where only a fraction of a pip can be the difference between win and loss tend to get the most complaints. For this reason they are probably best left alone.