This guest article was written by Simon Klein who is a professional trader with over 10 years of trading experience. Simon has a passion for trading and loves to train and coach others – whether a complete beginner or an experienced trader. He is also the founder of TradeSmart4x.com.
Binary Options are a hot topic at the moment. There is a lot of misinformation out there and conclusions are being drawn based on a lack of knowledge instead of being based on a deep understanding.
This article will cover the interesting topic about how to classify whether the activity you are doing is considered trading or gambling and will uncover how to ascertain whether what you are trading is a financial instrument or not.
It appears, based on a recent article, that regulators in different countries do not know whether to classify binary options as a financial instrument or gambling. This statement shows a shallow understanding of binary options as well as financial instruments. There are a number of types of binary options and this article appears to imply that there is only one. For example, there are fully regulated binary options that trade on the NYSE and NADEX. There is also a Binary Options Exchange where you can be the writer and seller of binary options.
Gambling or financial instrument?
According to the Merriam-Webster dictionary, gambling is defined as “to bet on an uncertain outcome”. Isn’t trading any financial instrument according to this definition gambling? Well, it is if you are just looking at the outcome of one individual trade in isolation. If on the other hand, you are trading a system that has a positive expectancy then the outcome of a large enough number of trades is not uncertain anymore – you will make money!
I would like to offer a different and novel approach to understanding the nature of trading and gambling.
The approach is based on a two prong analysis that looks at both the nature of the “instrument” that you are trading and how you are trading.
- What are you are trading? If there is no system that can be developed that has a positive expectancy, then you are gambling and what you are “trading” is not a viable financial instrument.
- How are you trading? If you trade any financial instrument without a strategy that has a positive expectancy, then you are gambling.
Let us take a look at a few examples to see whether you are gambling or trading.
- Playing the slot machines in a casino. This is clearly gambling as the odds are in the favor of the slot machines over time. If you play long enough you will always lose. The casino always wins.
- Trading options with a system that has a positive expectancy. This is clearly trading and not gambling as you will make money over time even though the outcome of any one trade is unknown.
- Trading stocks without a system that has a positive expectancy. This is clearly gambling according to our 2 prong test above, as it is uncertain whether you will make money over time. So in this example, you can see that even though you are “trading” a financial instrument, what you are doing is still considered gambling.
Expectancy type could settle the dilemma
To address the issue as to whether binary options are gambling or trading, you have systematically look at each category of binary options and decide whether you can develop a system that has a positive expectancy or not. If there does not exist a system of trading that has a positive expectancy, then you are gambling and what you are trading is not a financial instrument. If on the other hand, you can develop a system of trading that has a positive expectancy, then you are trading and what you are trading is a viable financial instrument.
If you take a look, on the surface, at trading binary options through an OTC (over-the-counter) binary options broker, it would appear that you may be gambling. This is because, on the other side of each of your trades, is the broker.
The odds are in the broker’s favor. This is because you can only be the buyer of the binary options. You can either buy a put or a call. If you win you will always profit less than what you risked. For example, in the language of most binary options brokers, you can make 80% return if you are right. This means that you will have to risk $100 to make $80 and if you are right 50% of the time, you will have a negative expectancy. The broker, on the other hand, will have a positive expectancy.
The only way that you can make money over time when your reward is less than your risk is ONLY if you are able to develop a system of trading that increases the percentage of winning trades to a point at which you will have a positive expectancy.