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The illegal world of CFDs and Binary Options

Created on 25 Jan 2021

Wraps up in 6 Min

Read by 4.5k people

Updated on 29 Jan 2021

Investors in India these days have a variety of avenues to trade in derivative instruments – financial rate agreements (FRAs), options, swaps, and futures. In its practical sense, Derivative trading is akin to gambling and is strictly regulated by the RBI and SEBI and laws like FEMA.

However, did you know there are certain derivative instruments whose trading is absolutely illegal in India? No? Well, here we will be discussing two of such instruments – contracts for difference (CFDs) and binary options. 

Let's get started. 

What are Contracts for Difference (CFDs)?

Contracts for difference (CFD) is an agreement, typically between a broker and an investor, which stipulates that the buyer must pay the difference between the current value of an asset and the asset value at the time of contract. 

The CFDs' key feature is that the investor never actually owns the underlying asset. Instead, the investor earns revenue based on the price change of that asset.

How did it all begin, and where is it headed?

Originally, CFDs were traded among banks and financial institutions. However, they have become popular with retail investors over the years because they allow investors to trade without owning any securities themselves. 

With their increasing popularity, CFDs are starting to face scrutiny from regulatory authorities who're imposing restrictions on their trading. There's an ongoing standoff between the CFD trading services providers and the regulatory authorities. However, many people have welcomed the restrictions from the regulators.

Features of CFDs

  • Investors do not own the asset when trading a CFD on an asset.
  • Unlike options or futures contracts, CFDs do not have an expiry date.
  • Trading a CFD attracts low to nil charges. Brokers providing CFD trading services don't charge any commission or fees on an entry or an exit trade. The brokers make money by making the investor pay the spread. 

Certain Terms regarding CFDs

Trading on CFDs is akin to gambling. A trader assumes a position based on his price belief. 

  • Going Long: When a trader expects a rise in the price of the underlying asset, he will go long, i.e., buy. Trading from the buy-side is called going long.
  • Going Short: When a trader expects a fall in the price of the underlying asset, he will go short, i.e., sell. Trading from the sell-side is called going short.

Understanding the Working of a CFD with an Example 

Imagine this; you are an investor. You have been noticing this one up-and-coming tech company, say TechCorp. 

Scenario 1

Scenario 2

Your belief: You think that the share prices of TechCorp will rise.

Your belief: You think that the share prices of TechCorp will fall.

What do you do? You buy CFD on these shares and take a long position.

What do you do? You sell CFD on these shares and take a sell position.

What happens if the prices rise? You get the difference between the opening and closing prices, i.e., you make a gain.

 

The higher the price rises, the bigger the gain you will make.

What happens if the prices fall? You get the difference between the opening and closing prices, i.e., you make a gain.

 

The lower the price falls, the bigger the gain you will make.

What happens if the prices fall? You pay the difference between the opening and closing prices, i.e., you make a loss.

 

The more the price falls, the more the loss you will make.

What happens if the prices rise? You pay the difference between the opening and closing prices, i.e., you make a loss.

 

The more the price rises, the more the loss you will make.

Pros of Investing in CFDs

  • CFDs allow the investors to trade on the price movement of various assets like Exchange Traded Funds, stock indices, and commodity futures.
  • The investors enjoy all the benefits and bear all the risks associated with owning a security without actually owning the security.
  • CFDs utilize leverage permitting the investors to put up a small percentage of the trade amount with a broker.
  • CFDs facilitate investors to quickly assume a long or a short position or a buy and sell position. 

Cons of Investing in CFDs

  • Although leveraging through CFDs can amplify the investor gains, it has the potential to magnify the losses as well.
  • Extreme price fluctuations can cause a widespread between the bid (buy) and ask (sell) prices from a broker.
  • The CFD market is unregulated. It is illegal to trade CFDs in many countries. 
  • Traders have to rely on the credibility and reputation of the CFD brokers as the regulatory legitimacy has not been granted to the CFDs.
  • Investors in a losing position can expect a margin call from their broker, asking them to deposit additional funds.

Is Trading on CFDs Legal in India?

CFD trading is illegal and prohibited in India. The prohibitions have not been lifted despite several pleas for amendments from many brokerage firms and individuals. However, if you are keen on CFD trading, you would have to open an account with a broker outside India that provides CFD trading services. Since the broker is not located in India, you can trade on CFDs using their account, provided CFD trading is permitted in the broker's country.

One should, however, note that this method of CFD trading would not be cheap. You should not fall for more affordable brokers because you would be putting your money in jeopardy. There is a high chance of the emergence of liquidity issues during extreme market volatility.

What are Binary Options?

A binary option is another financial product in which the parties to the transaction are assigned one of the two outcomes based on whether the option expires in the money. The binary option outcome depends on a 'yes or no' proposition, therefore the name 'binary.'

Types of Binary Options

Binary options are unconventional options that generate a payout of either a fixed monetary sum or absolutely nothing. Binary options can be either asset-or-nothing binary options or cash-or-nothing binary options.

Asset-or-nothing binary options pay a fixed amount of cash if the option expires in the money. In contrast, cash-or-nothing binary options pay the value of the underlying security.

Binary options are also known as digital options, fixed return options (FROs), and all-or-nothing options.

Features of Binary Options

  • Binary options depend on a 'yes or no' proposition. Traders make money if the option expires in the money and lose money if the option expires out of the money.
  • Traders cannot take a position in the underlying security.
  • There is automatic debit or credit in the trader account when the option expires.

Understanding the Working of Binary Options with an Example

Imagine this; you are a trader, and you come across a share of a company (say) XYZ, which is selling at Rs.25 on January 25, 2021, at 10.45 AM. You have a decision to make – whether the price will rise or will it fall?

Scenario 1

Scenario 2

Your belief: YES, the share prices will rise.

Your belief: NO, the share prices will not rise, but will fall.

What do you do? Based on your price belief, you invest Rs. 100 on the trade.

What do you do? Based on your price belief, you invest Rs. 100 on the trade.

What happens if the prices rise above Rs. 25? You will receive the payout as per the terms agreed.

 

If the payout were 75%, the binary broker would credit your account with Rs. 75.

What happens if the prices fall below Rs. 25? You will receive the payout as per the terms agreed.

 

If the payout were 75%, the binary broker would credit your account with Rs. 75.

What happens if the prices fall below Rs. 25? Your price belief is proven wrong, and you lose the entire Rs. 100 invested in the trade.

What happens if the prices rise above Rs. 25? Your price belief is proven wrong, and you lose the entire Rs. 100 invested in the trade.

Is Trading on Binary Options Legal in India?

Just like CFDs, trading on binary options is also illegal in India. The Indian financial sector is regulated by the RBI and SEBI that do not favour investing in binary options. Prohibitions on trading in binary options or forex trading in India are also present in the Foreign Exchange Management Act (FEMA). 

Indian traders keen on binary trading have to seek offshore binary options brokers as there is hardly any broker in India providing binary option trading services. No binary options are listed on any of the stock exchanges in India. 

Closing Remarks

Contracts for difference (CFDs) and Binary Options are unconventional financial instruments rooted in unregulated markets. Trading on these financial products is illegal in India, although it is openly advertised, with celebrities endorsing them.

With this article, we tried to explain how trading in such derivative instruments entails risks that can harm your investment portfolio. Be careful, and do not find yourself captive in this illicit world of illegal CFDs and binary options.

Stay Positive, Test Negative!

Happy Investing. 

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