Let's toss a coin: if it's heads you double your investment, if it's tails you lose everything. That's the essence of a binary option. Many unscrupulous people are packaging these as investments, but they are not investments, they are gambling! Read on if you want to understand what a binary option is and, more generally, what options are and why binary options are like gambling.

I have to confess that I love options! I taught traders at an investment bank all about options for two years and so I'm fairly familiar with how they work, but even I would not trade binary options. Okay, if you've been trading options for years it may make sense to play around with binary options, but for someone who's new to investment it really is like juggling chainsaws. Thanks to a regulatory loophole companies that are selling binary options to unsophisticated investors are able to operate within the EU and don't need a license from the FCA or from the Gambling Commission.

To understand why this is gambling and not investment let's step back and see what an option actually is. As its name suggests it's an...

• option (but not an obligation)
• to buy something (call option) or sell something (put option)
• for a fixed amount (notional amount)
• at a fixed price (strike price)
• at a fixed time in the future (the expiry date)

Although that seems like a fairly simple setup the consequences can get a little bit hairy, and for nerds like me the mathematics of option pricing is rather exciting. But you don't need lots of maths to understand the essence of an option. All you really need to know are the payoffs.

The case you're probably familiar with is the one on the left where you simply buy a stock. You buy it because you think the price is going to go up. And your profit goes up one for one and down one for one as the share price moves up and down. The upside of an equity is unlimited and the downside is that you could lose your whole investment. But the key thing here is the payoff is linear. If the share price goes up 1% the value of your investment goes up 1%. If the share price goes down 1% you'll lose 1% on your investment.

What if you don't want the downside? What if you just want to buy the upside of the stock at some point in the future? In that case you can buy a call option. So let's say the stock is trading at £100 today, and in one month's time you think it's going to go up. You can buy a call option to buy the stock at £100. If in one month's time the stock price is below £100 you don't exercise your call option. Remember it's a right to buy not an obligation to buy at £100. If the price falls to £99 you just won't exercise the call option and you'll lose what you paid for the call option upfront. But if the share price is £110 you certainly would exercise the call option! You can buy it at £100 and you can sell it instantly for £110. And that way you make a healthy profit. This is really neat because all of your losses are paid upfront. The most you can lose is the price of the option, and usually that's a fraction of the cost of buying the stock. That's the beauty of an asymmetric payoff.

But the aspect of options which subtle and tricky to understand, particularly for people who are new to investment, is leverage. Consider two scenarios shown below, one in which the share price moves up by 30% (blue boxes on the left) and one in which it moves down 30% (red boxes on the right). If we buy the share we'd either make a 30% gain or a 30% loss. We'd pay £100 upfront and we'd either pocket £130 pounds or £70 after one year has passed.

What if we buy a call option? The price we pay upfront is just a fraction of the £100, say £20. Now when the share price moves up by 30% we have an option to buy at £100. Do we do that? Yes! We buy for £100 and we sell in the market for £130 and we pocket that £30. But here's the beauty. We only paid £20 pounds upfront so instead of a 30% return our return is boosted to 50%. That's the good side of leverage. Here's the ugly side. If the price had moved down by 30% well we certainly wouldn't exercise our option in that case. Why pay £100 for the stock if we can buy it in the market for £70? The £20 we pay for the option would be lost and option would expire worthless. Our return in this case would have been a loss of 100%, and the probability of that loss is fairly high, it would have been about 50%.

If you compare the returns in those two scenarios for the share we would have gained 30% and for the option we would have gained 50%. In the down scenario the share would have lost 30% and the option would have lost 100%. That's what leverage does: it amplifies our gains and our losses. If you're investing your life savings leverage should be used with a great deal of caution.

So what's a binary call option? Instead of the hockey-stick payoff that we saw before the payoff is now a step function which means that if the stock price moves above £100 we get the full payoff but no more. Our upside is no longer unlimited. It's now limited by the binary call option. The downside is limited just like it would be with a call option. If the stock price is below 100 at expiry we lose everything. This is much more akin to the coin toss example which used in the introduction. Furthermore binary options are usually very short-term and they carry leverage which, to me, is pretty close to the definition of gambling.

So is the UK regulator, the Financial Conduct Authority, asleep? Fortunately not! But as the FCA says on their website they don't regulate binary options. If a firm is located in the UK and they deal in binary options they need to be regulated by the Gambling Commission. But there are many worrying reports about consumers being scammed by fraudsters who claim to be selling binary options. So if you are going to trade these, and I wouldn't unless you understand options, if the company is based in the UK check that they're regulated by the Gambling Commission. If it's in an EEA member state check whether they're authorised to deal in binary options or alternatively that they're authorised to deal these options in their home country.

So the message is:

• If you trade binary options avoid companies which are not regulated
• Always follow the very simple guideline: don't invest in things you don't understand!

If you've lost money with binary options please contact us. Do you agree with us that it's gambling not investing? You can tweet us @PensionCraft or contact us on Facebook.