Binary Options Trading Regulation: Is it Legal?

Before we start this discussion, I think it’s crucial to differentiate between binary options trading that is illegal as opposed to unregulated. To be specific, if you open a real money trading account with a FINRA-licensed broker you pretty much know what you are getting. The traditional brokers or exchanges make their money based on the margins or percentages charged according to the volumes of trades executed.

Contrarily, the CYSEC-licensed brokers operate differently. In their business model the trading algorithm ignores the volume of trades in this context. Of course they want you to trade more, but only in the  sense that it causes the trader to continue investing and depositing money. Their operating profit originates from a very simple formula; namely deposits less withdrawals. There is a good and bad side to this, just like everything else, however, it’s worth while mentioning that the newer brokers offer bonuses or an “educational allowance” that boosts your bankroll and allows you to execute more trades with a small investment, however this does not come without a price.

What is CYSEC and Why is it Important?
The Cypress Securities and Exchange Commission has become the main regulatory body governing licenses, compliance, fair trade protocols, and trading guidelines for any binary options platform seeking a formal seal of approval outside of the United States. Because Cyprus is de facto a part of the European Union, their commission has more weight as opposed to other bodies. Furthermore, it allows the platforms to receive licensing from one source instead of getting it from each individual country.

Part 3 of the 3rd Appendix – Law 144(I)/2007 – “financial instruments”, defines the basic regulatory outline for binary options and states that “CySEC has decided to include binary options in the list of financial instruments that fall within the remit of the Investment Services and Activities and Regulated Markets Law of 2007-2009 (the ‘Law’).”

The Committee of European Securities Regulators (CESR)

CySEC grants a Cyprus Investment Firm (CIF) License to all brokers/platforms submitting their requests according to the standard format and adhere to the CESR guidelines on risk measurement and the calculation of global exposure and counterparty risk for Undertakings for Collective Investment in Transferable Securities (UCITS). Cat got your tongue? Well, join the club, but here’s my attempt to outline the main points at least in broad strokes.

The CESR sets “the actual conversion of financial derivatives into the equivalent position in the underlying assets”, and defined the methodologies for netting and hedging with respect to global exposure. For this it uses a VaR formula as well as additional safeguards.

The conversion methodologies for derivatives and exotic options are called “variance swaps”, which are the actual contracts that allow the trader to gain exposure (speculate) to the variance usually referred to as the “squared volatility” of the underlying asset. Now, the process is performed in the present, while factoring in implied volatility based on historical data (predictive analysis or modeling).

The strike as well as the variance notional are displayed below in the context of volatility. The formula for the variance notional can be seen below:

                                                                                Vega notional
                                            variance notional =  —————-
                                                                                    X2 Strike

The “vega notional” is but a theoretical measure of the profit or loss resulting from a 1%
change in volatility ratios. Since realized volatility must be greater than null (0), a long swap position has preset values based on the maximum losses incurred. The max possible loss on any given “short swap” is more often than not limited by the inclusion of a fixed cap on volatility ranges.

The methodology for conversion that’s usually implemented for trading contracts can be seen below:

More than anything the formulas above are a part of the regulators attempt to create an insulated trading environment that allows the trader to take risk on one hand, while at the same time protect him by instituting an envelope of safeguards that when implemented by binary options or Forex trading platforms (and the actual brokers themselves acting as proxy) the algorithmic code allows for a safe, legal, as well as regulated trading.

For US citizens or residents trading out of American soil, the fully regulated exchanges such as NADEX and/or the CBOE allow trading according to the traditional VIX Call/Put ratios that are presented every day in the form of a market summary report. Again, for the better or for the worse, the difference between these exchanges and the CySec brokers is more than anything in the actual business raison d’être.

The exchanges require a large volume of traders in order to exist, since the contracts are based on cash liquidity originating from trading volume. The commissions are charges per trade depending on the contract rates and with out regards to win or lose. The new brokers operate like a casino in the sense that you are trading against the house and there is no need for trading volume and their profits originate from trades originating from deposited money lost on losing trades. Still, if you stick to their terms and conditions and trade according to the guidelines with one of our recommended brokers, and have a solid strategy, you stand a good chance of making a significant amount of money with minimal risk.

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