Binary options are an alternate strategy to play the foreign currency (forex) marketplace for traders. Although they’re a comparatively expensive strategy to trade forex compared with the leveraged spot foreign currency trading offered by a growing variety of brokers, the incontrovertible fact that the utmost potential loss is capped and known prematurely is a significant advantage of binary options.
Defining Binary Options
Binary options have two outcomes: They settle either at a pre-determined value (generally $100) or at $0. This settlement value depends upon whether the worth of the asset underlying the binary option is trading above or below the strike price by expiration.
Binary options could be used to invest on the outcomes of varied situations: Will the S&P 500 rise above a certain level by tomorrow or next week? Will this week’s jobless claims be higher than the market expects? Or will the euro or yen decline against the U.S. dollar today?
For instance, say gold is trading at $1,195 per troy ounce currently and you might be confident that it can be trading above $1,200 later that day. Assume you may buy a binary option on gold trading at or above $1,200 by that day’s close, and this selection is trading at $57 (bid)/$60 (offer). You purchase the choice at $60. If gold closes at or above $1,200, as you had expected, your payout can be $100, which implies that your gross gain (before commissions) is $40 or 66.7%. Then again, if gold closes below $1,200, you’d lose your $60 investment, for a 100% loss.
Binary Option Buyers and Sellers
For the customer of a binary option, the fee is the worth at which the choice is trading. For the vendor of a binary option, the fee is the difference between 100 and the choice price and 100.
From the customer’s perspective, the worth of a binary option could be thought to be the probability that the trade can be successful. Due to this fact, the upper the binary option price, the greater the perceived probability of the asset price rising above the strike. From the vendor’s perspective, the probability is 100 minus the choice price.
All binary option contracts are fully collateralized, which implies that each side of a selected contract—the customer and seller—need to put up capital for his or her side of the trade. So if a contract is trading at 35, the customer pays $35, and the vendor pays $65 ($100 – $35). That is the utmost risk of the customer and seller and equals $100 in all cases.
Thus the risk-reward profile for the customer and seller on this instance could be stated as follows:
Buyer
- Maximum risk = $35
- Maximum reward = $65 ($100 – $35)
Seller
- Maximum risk = $65
- Maximum reward = $35 ($100 – $65)
Example of Binary Forex Markets: Nadex
Binary options in forex can be found from exchanges reminiscent of Nadex, which offers them on the most well-liked pairs reminiscent of USD-CAD, EUR-USD, and USD-JPY, in addition to on quite a lot of other widely-traded currency pairs.
Founded in 2004, the North American Derivatives Exchange—or Nadex—is a Chicago-based financial exchange that focuses on short-term binary options and spreads. The corporate is a subsidiary of London’s IG Group (LON: IGG) and is regulated by the Commodity Futures Trading Commission (CFTC). Binary options are legal and available to trade within the U.S., but only on a CFTC-regulated exchange like Nadex (you may also trade binary options through the Chicago Board Options Exchange).
Nadex binary options are offered with expirations starting from intraday to day by day and weekly. The minimum tick size on spot forex binaries from Nadex is 0.25, and the tick value is thus $0.25. The intraday forex binary options offered by Nadex expire hourly and as often as every five minutes, while the day by day ones expire at certain set times throughout the day. The weekly binary options expire at 3 P.M. on Friday.
For many forex contracts, Nadex calculates the expiration value by taking the midpoint prices of the last ten trades within the forex market, eliminates the very best and lowest three prices, after which takes the arithmetic average of the remaining 4 prices. For top-activity names, it takes all midpoint prices collected within the last ten seconds of trading, trims the very best and lowest 30% and averages the rest.
Examples of Binary Options in Forex
Let’s use the EUR-USD currency pair to reveal how binary options could be used to trade forex. We use a weekly option that can expire at 3 P.M. on Friday, or 4 days from now (or Monday). Assume the present exchange rate is EUR 1 = USD 1.2440.
Consider the next scenarios:
1. You suspect the euro is unlikely to weaken by Friday and may stay above 1.2425.
The binary option EUR/USD>1.2425 is quoted at 49.00/55.00. You purchase 10 contracts for a complete of $550 (excluding commissions). At 3 P.M. on Friday, the euro is trading at USD 1.2450. Your binary option settles at 100, providing you with a payout of $1,000. Your gross gain (before taking commissions under consideration) is $450, or roughly 82%. Nonetheless, if the euro had closed below 1.2425, you’d lose your entire $550 investment, for a 100% loss.
2. You might be bearish on the euro and imagine it could decline by Friday, say to USD 1.2375.
The binary option EUR/USD>1.2375 is quoted at 60.00/66.00. Since you might be bearish on the euro, you’d sell this selection. Due to this fact, your initial cost to sell each binary option contract is $40 ($100 – $60). Assume you sell 10 contracts, and receive a complete of $400. At 3 P.M. on Friday, let’s say the euro is trading at 1.2400.
For the reason that euro closed above the strike price of $1.2375 by expiration, you’d lose the complete $400 or 100% of your investment. What if the euro had closed below 1.2375, as you had expected? In that case, the contract would settle at $100, and you’d receive a complete of $1,000 to your 10 contracts, for a gain of $600 or 150%.
Additional Basic Strategies
You do not need to attend until contract expiration to appreciate a gain in your binary option contract.
As an illustration, to illustrate by Thursday the euro is trading within the spot market at 1.2455, but you might be concerned about the potential for a decline within the currency if U.S. economic data to be released on Friday are very positive. On this case, your binary option contract (EUR/USD>1.2425), which was quoted at 49.00/55.00 on the time of your purchase, is now at 75/80. Due to this fact, you may sell the ten option contracts you had purchased at $55 each, for $75, and book a complete profit of $200 (or 36%).
You may as well placed on a mixture trade for lower risk/lower reward.
Let’s consider the USD/JPY binary option for example. Assume your view is that volatility within the yen—trading at 118.50 to the dollar – could increase significantly, and it could trade above 119.75 or decline below 117.25 by Friday. You, due to this fact, buy 10 binary option contracts (USD/JPY>119.75, trading at 29.50/35.50) and likewise sell 10 binary option contracts (USD/JPY>117.25, trading at 66.50/72.00). Due to this fact, you pay $35.50 to purchase the USD/JPY>119.75 contracts, and $33.50 (i.e., $100 – $66.50) to sell the USD/JPY>117.25 contracts. Your total cost can be $690 ($355 + $335).
Three possible scenarios arise by option expiration at 3 P.M. on Friday:
- The yen is trading above 119.75. On this case, the USD/JPY>119.75 contract has a payout of $100, while the USD/JPY>117.25 contract expires worthless. Your total payout is $1,000, for a gain of $310 (or about 45%).
- The yen is trading below 117.25. On this case, the USD/JPY>117.25 contract has a payout of $100, while the USD/JPY>119.75 contract expires worthless. Your total payout is $1,000, for a gain of $310 (or about 45%).
- The yen is trading between 117.25 and 119.75: On this case, each contracts expire worthlessly and also you lose the complete $690 investment.
The Bottom Line
Binary options are a useful gizmo as a part of a comprehensive foreign currency trading strategy but have a few drawbacks in that the upside is proscribed even when the asset price spikes up, and a binary option is a derivative product with a finite lifespan (time to expiration).
Nonetheless, binary options have quite a lot of benefits that make them especially useful within the volatile world of forex. For starters, the danger is proscribed (even when the asset prices spikes up), the collateral required is kind of low, and so they could be used even in flat markets that will not be volatile. These benefits make forex binary options worthy of consideration for the experienced currency trader.