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How do binary options brokers make money?

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Lesson 3

When you trade with a brokerage firm, be it forex or binary options, most traders don't bother with how things work. For many, trading is all about placing trades and trying to make a profit.

While this idea is quite well entrenched, it is also important traders take the time to understand how binary brokers make money.

One can have a trading account at a binary options broker or forex broker. There are also CFD brokers as well and, of course, options trading brokers. Brokers usually take the orders placed by their customers, who are the traders, and then pass those orders on to the market.

Knowing how the binary options brokers make profit can help traders understand the complete process, as well as help them pick the right broker. The truth is that after understanding how the binary brokerage works, you can see a completely different picture.

Furthermore, you will discover why using a regulated firm is better than trading with an unregulated broker.

How do binary brokers make profit?

With binary options brokers, the contracts placed are executed in-house. This is because binary options are synthetic assets. There is no EUR/USD binary options instrument, for example.

Rather, the binary options prices are derived from the underlying price of the asset. So, in the EUR/USD example, the price of the contract is based on the actual price from the spot forex markets.

The binary broker works as a betting house where traders are speculating whether the EUR/USD price will be higher or lower at expiry. This is similar to betting whether Chelsea vs West Ham will finish Under or Over 2.5 goals.

For example, the broker may offer you a 90% payout on every successful trade. In this case, you are placing a $100 trade, and you expect a $90 return, but if your prediction is incorrect, the broker will profit $100.

In other words, when traders place Call or Put options, the broker executes them in-house and becomes the counter-party to its customers.

One might think of this is a risky business for the brokers and it is. However, there are ample checks in place to ensure the broker is well protected, especially against winning traders.

Furthermore, the way the counter-party trades are executed is also rather complex, all in the effort to minimize the broker’s risk.

Binary options exchanges

There is one well-known binary options exchange: NADEX (North American Derivatives Exchange). The exchange offers binary options and spreads, and it matches the traders and the market makers on every trade.

NADEX offers different binary options on each asset. When we say different, we mean in terms of target price and expiry time. A trader can buy the option if he or she believes the market price will go higher or sell it if he or she predicts the opposite.

The exchange makes profit by charging a commission on all trades. It doesn’t operate like a betting house, which means when a trader makes a profit, NADEX doesn’t lose. The money is exchanged between traders and market makers.

To provide liquidity, the binary exchange works with multiple market makers, including MRM, which is a subsidiary of IG Group, the same company that owns NADEX.

To summarise, with an exchange, the trades actually go on the market; with binary brokers, they stay “in-house”.

How forex brokers work

Forex brokers operate in two ways. They can either be a market maker or an exchange-based model (ECN/STP).

Market maker

A market maker, as the name suggests, makes the market. There are certain advantages and disadvantages to this. The main advantage is that, with a market maker, the broker will guarantee that your trades will be executed at the price you wanted.

This is because the market maker will take a counter-party position. So, if you purchased EURUSD at 1.1100, the market maker will sell you the EURUSD as 1.1100. While you have a long position in EURUSD, the market maker has a short position.

The downside of this is that when there is a trader with consistently losing positions, the market maker makes money.

Exchange ECN/STP

The other way of operating a forex brokerage is as a dealer or an ECN or STP broker. In this instance, the broker does not take any position; instead, it passes your orders into the market. This means your positions are executed against the best orders that are available.

The advantage here is that your broker is not your counter-party to your trade but rather you trade against other traders and market participants. For facilitating this, the broker charges a commission.

The term commission is often explained by brokers, such as market makers, as being expensive, but the fact is, commission-based trading with a brokerage is ideal.

After all, you pay a commission to your real estate broker when they find you a seller. ECN and STP brokers operate similarly. They can either match your trades with other traders in their network or pass your orders onto the general market.

The disadvantage of this is that you might not get the best order execution. Although this is not the case all the time, in some instances, you can see that ECN or STP brokers will fail to get the best price for you due to lack of liquidity.

Forex vs Binary brokers

The binary brokers work in a similar fashion as the market maker. The only difference is everything is synthetic or derived from the underlying markets. So, every Call or Put option trade executed will either make or lose money for the binary broker.

How to choose your broker

So, does this mean that you should stop trading with a binary broker? The choice is up to you. If you are a good trader, and you are consistently winning, then it shouldn’t be a problem. Finding the right broker to trade with is important, however.

With an unregulated firm, there is no audit on its business practices, and in such cases, this gives rise to potential fraud. Unregulated binary brokers can, for example, give you the wrong price so that your trade expires out of the money and so on.

With a regulated company, the entire business is subject to certain audits and principles that must be followed. This makes trading with a licensed binary broker more transparent.

This is the reason why traders flock to regulated brokerages (either forex or binary options) as their business practices are much more consistent, professional and transparent.