Brokers in forex markets and stock markets make money when they charge commissions for their services irrespective of whether or not the traders make money. Binary brokers, on the other hand, do not charge commissions or spreads for their services.
For this reason, many people do not understand how binary brokers make money and it doesn’t help that binary options trading is considered by some policymakers a form of gambling. The trade is also strictly regulated – many binary options are traded in jurisdictions outside the US but American citizens can still access them via select platforms.
These factors make binary trading relatively removed from the public domain, but in this text, we shall attempt to demystify binary brokerage.
Let’s learn about How binary brokers make money
As we have established, binary brokers are unlike brokers in the stock market and the forex market; they do not charge commissions on the trades. Whereas it is obvious that the latter (stock and forex market brokers) earn money from the commissions they charge, you are right to speculate where binary brokers earn their dough – because otherwise, they would be out of business. There are three ways by which binary brokers make money:
- They make money from lost trades
- They earn a commission from trader-to-trader binary exchanges
- They earn money from the pricing differences in binary options
- Money from lost trades
One of the main appeals of binary trading is in the simplicity with which it operates. Traders either make or lose a predetermined amount of money. When traders lose money, where does it go? Two places:
- To pay the winning trades
- To the brokers
What would happen if all the traders made the right decisions and earned profits? In that scenario, the broker would be out of luck because they would have to pay the profits out of their own pocket and would, therefore, lose money. But the probability of that ever happening is almost zero.
A Hypothetical Case
Consider a hypothetical case in which a broker has 1000 customers. Each of these customers bet $1 on a forex option, the EUR/USD pair, for example. When all traders place their bets, the broker has $1000. Half of the traders (500) predict that the currency pair will trade above 1.2 at midnight while the other half bet that the currency pair will trade below 1.2 at midnight. The return percentage set by the broker is 87%. When midnight arrives, the currency pair trades above 1.2 as the first group predicted. When it comes to compensation, each of the 500 traders is paid $1.87 which translates to $935 in total. From the initial pool of $1000, the broker earns $65.
The hypothetical scenario described above is merely theoretical but it demonstrates that even if it happens, the broker makes money.
As for the return percentage, the brokers are always careful to pick one that it will yield them a profit at the very least. In the hypothetical scenario above-described, if the return percentage was 95%, the returns would be diminished and at 100%, the returns would be zero. To maximize returns while retaining a reasonable profit for the winning trades, the percentage is hardly ever set above 90%.
In reality, at any moment, the average broker hosts multiple traders making different trades with varying possibilities. More traders lose money than the ones that make money which means that the brokerage business is always profitable.
- Commissions Earned from Trader-to-Trader Binary Exchanges
Some binary brokers run schemes in which traders can exchange binary options amongst themselves. In so doing, these traders are betting against each other; when a trader loses money, another trader gains it directly. The traders pay a commission to the broker. This system is unlike the conventional one where traders are betting against the broker with the money lost going directly to the broker.
The commission that the broker charges is merely a charge for providing the traders with a platform. The cut is relatively small per trade and looking at the returns earned from the winning trader’s perspective, they are hardly dissimilar to the returns accrued from conventional binary options trades.
- Profits Made from Pricing Discrepancies
Binary brokers can also make money from the pricing variations of the binary options. If you examine the prices, binary options are priced at a slightly higher price than those that are in the market. And when you examine the expected payout, it is not calculated based on a percentage. A certain amount is normally retained by the broker. This cut provides them with another avenue to make money.
Do Binary Brokers Want You to Lose?
Since they make money when traders lose it, you would be forgiven for assuming that the brokers want the traders to lose money to maximize their profits. But the truth is far from it: If you understand how binary brokers make money, you know that a majority of traders lose money and the brokers also have the other avenues to make money described above. Therefore, they don’t really care whether a certain trader beats them because that loss will be offset by the many other losses made and at the end of the day, they will earn a profit.
Unfortunately, this business is prone to fraudsters – brokers who are bent on conning people. Scam brokers talk a good game and maintain a deceptive appearance. They usually offer to help you to make more money but instead of actually helping, they manipulate the software to show you fake “returns” to make you happy. If at one point after “earning profits,” you wish to withdraw your money, you will realize that they have already stolen it.
Various binary options brokers have different business models. The manner in which they make money relies on the models they choose to operate their business. As a trader, you should examine how a broker makes money and check whether they charge extra cash for their services. Compare the costs before you find your broker and ensure that they are legitimate to avoid losing money. If you want to be a binary broker, be a legitimate broker because you can still make a lot of money by doing honest work. However, you need to have the resources to pull it off: Money, licenses, office space, equipment, and staff. Penetrating the market is also not easy because the competition will be other well-run brokerages that have been doing it for years.