Written by Sven Roering
Reading time: Less than 5.5 minutes
I’ve been reading about a few investment platforms that I can register for online, that allow me to manage my investments with relative ease. Some of the platforms advertised seem to offer products producing very high annual returns, some of which I am not familiar with, such as Binary Options and Contracts for Difference (CFDs). Can you explain these types of products and let me know if they are suitable for retail investors?
In the age of the internet more and more individuals are signing up for investment, securities and trading accounts online. This has unleashed a new “DIY” age when it comes to personal investing, which is fantastic in that it gives individuals direct access to capital markets and ultimately leads to the improvement of the global economy.
The internet also creates a platform for opportunistic service providers to create products and services which are designed to dupe customers explicitly, or are marketed as being relatively low-risk and suitable for individuals to purchase directly, when they are in fact extremely complex and not suitable for the general public.
What are binary options?
Binary options are the proverbial new-kid-on-the-block when it comes to investment products. Platforms offering binary options are marketed aggressively on the internet, and often contain testimonials from customers who claim to make USD5,000 per week from trading while sitting on the sofa. The truth is that the outcome from investing in these products is, by definition, binary. For example, you place a bet and you will experience two outcomes: win some money or lose the entire amount you have invested. The outcome is much like betting on the winner of a football match, which is why binary options are regulated as gambling products and not as financial instruments in many countries.
How do binary options work?
The mechanics of a binary option are fairly simple: an investor buys a contract with the provider that states, for example: you pay USD100 for a contract that states that if there is a positive move in the price of Apple shares between 11:00am–11:10am, you will receive USD1,000. If the share price has no movement, or is negative during that time, you will receive nothing and lose the amount of your initial investment. There are many different return outcomes available for trading on many different underlying securities. I would recommend doing extensive research before doing this type of trading, specifically on the platform itself, as many are blatant scams.
How do CFDs work?
Contracts for Difference (or CFDs) are more conventional instruments and have been around for longer than binary options. They are far more regulated than binary options and give investors the option to profit from moves in a company’s share price without having to physically own the shares. These contracts are bought directly from a broker, and allow investors to profit from indirectly owning a specific amount of company shares by only contributing a fraction of the cost of what the shares would cost collectively. For example, you believe that Amazon is the best, most innovative company in the world and you would like to own Amazon shares. The problem is that you only have USD 100 in life savings and one share of Amazon costs around USD 900. You could use a CFD where you are only required to deposit as low as 2% of the total value of the transaction you desire. Therefore, with your USD100 you would be given indirect exposure to USD5,000 worth of Amazon shares. If Amazon shares increase by 1% in value during that specific trading day, your “indirect” investment value will grow from USD5,000 to USD5,050 and you will pocket USD50 which is the difference. So, on a small USD100 investment you have made USD50 profit on your favorite company, which is an equivalent to a 50% return for you. The main pitfall is that this type of investing has a high risk of permanent capital loss, and the trading fees are very high.
Signing up for any type of exotic investment online might seem easy and convenient, but the pitfalls are prevalent and perilous. Try not to use your life savings and pension cash on exotic trading.