How Binary Option Brokers Make Money.
Many new traders often wonder, how do binary option brokers make a profit? While we will focus on binary options in this article, these concepts are applicable to many other financial products such as forex and CFDs.
If you are still wondering, what are binary options? We’ve written an article on that here. You can also test out placing live binary options trades on the Zentrader demo platform (no sign up required).
Profits on Binary Options.
Payout rates on binary options are high. For example our current top broker Zentrader offers payouts of upto 195% in as little as 30 seconds. Have you ever wondered where the broker profit comes from?
Zentrader Trading Platform — Zentrader.com.
Lets first break down what a payout includes.
Say I invest $1000 in a 30 second binary option on the GBP/USD forex pair. The payout is 195%, therefore if I predict correctly I will receive $1950 on trade expiry.
Initial investment of $1000 + $950 profit on the trade = $1950.
The next important concept is market making.
What is market making?
As the broker is offering you the constant ability to either BUY or SELL the asset, this is called "making a market" in that particular asset.
Remember how in the above example a binary option trader makes a 95% return when they predict correctly, auto trading and loses the investment amount when they are incorrect? This 5% is theoretically the brokers margin.
While you may BUY or SELL when you place your trade, binary option auto tradig a broker relies on having a large number of clients all trading at once. In theory, all buyers and sellers positions match over time and the broker makes this 5% margin.
But what happens when all clients are trading in one direction, either BUYING or SELLING?
Broker Takes on the Risk.
In this scenario, the broker is taking on the risk themselves as they are making a market in the asset. They are taking the other side of the trade as their client book is not balanced.
In most instances, these short term imbalances in client positions will cancel each other out i.e. the expected 5% broker margin will sometimes be higher or lower.
Broker Risk Management.
In extreme scenarios where clients are positioned on one side of the market and the size of the positions are beyond the broker’s risk limits, the broker may hedge their position. To do this the broker will go into the underlying market (e.g. forex or futures) and take an opposite position to reduce the risk on their client orders at expiry.
There is no fixed rules here, risk management is often called an art for this reason.
Part Two will discuss binary option broker hedging, Auto Trading risk management and other theory of the binary options market. If you haven’t tried trading binary options, make sure you check out our current list of top rated brokers here.