Trading Forex With Binary Options

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Trading Forex With Binary Options

For traders, binary options provide an alternate method to participate in the foreign currency (FX) market. Although binary options are a more costly method to trade forex than the leveraged spot forex trading provided by an increasing number of brokers, the fact that the maximum possible loss is limited and known in advance is a significant benefit.

Defining Binary Options

Binary options have two outcomes: they settle at a predetermined value (usually $100) or at nothing. This settlement value is determined by whether the asset underlying the binary option is trading above or below the strike price at the time of expiry.

Binary options may be used to speculate on the outcomes of a variety of scenarios, including: Will the S&P 500 break through a specific level tomorrow or next week? Will this week’s unemployment claims be greater than expected? Will the euro or the yen fall against the US dollar today?

For example, suppose gold is now priced at $1,195 per troy ounce and you are convinced that it will trade over $1,200 later that day. Assume you can purchase a binary option on gold that is trading at or above $1,200 at the end of the day, and that option is trading for $57 (bid)/$60 (offer).You purchase the option for $60. If gold closes at or above $1,200, as projected, your payoff will be $100, resulting in a gross gain of $40 (before fees) or 66.7%. If gold falls below $1,200, you will lose your $60 investment, resulting in a complete loss.

Binary Option Buyers and Sellers

The cost of a binary option for the buyer is the price at which the option is trading. The cost for the seller of a binary option is the difference between 100 and the option price plus 100.

The price of a binary option may be seen as the chance that the transaction will be successful from the buyer’s viewpoint. As a result, the higher the binary option price, the greater the estimated likelihood that the asset price would rise over the strike. The likelihood is 100 minus the option price from the seller’s viewpoint.

All binary option transactions are completely collateralized, which implies that both sides of the trade—the buyer and seller—must put up cash for their respective positions. So, if a contract is trading at $35, the buyer will pay $35 and the seller will pay $65 ($100 – $35). This is the buyer’s and seller’s maximum risk, and it is always $100.

  Trading Account

In this case, the risk-reward profile for the buyer and seller is as follows:

Buyer

  • Maximum risk = $35
  • Maximum payout = $65 ($100 – $35).

Seller

  • Maximum risk = $65
  • The maximum award is $35 ($100 – $65).

Example of Binary Forex Markets: Nadex

Binary options in forex are accessible through exchanges such as Nadex, which provides them on prominent currency pairings such as USD-CAD, EUR-USD, and USD-JPY, as well as a variety of other commonly traded currency pairs.

The North American Derivatives Exchange, or Nadex, is a Chicago-based financial exchange that specializes in short-term binary options and spreads. It was founded in 2004. The Commodity Futures Trading Commission regulates the corporation, which is a subsidiary of London’s IG Group (LON: IGG) (CFTC).Binary options are legal and tradeable in the United States, but only on CFTC-regulated exchanges such as Nadex (you can also trade binary options through the Chicago Board Options Exchange).

Nadex binary options have expiry dates ranging from intraday to daily and monthly. The minimum tick size on Nadex spot forex binaries is 0.25, hence the tick value is $0.25. Nadex’s intraday forex binary options expire hourly and as often as every five minutes, whilst the daily ones expire at certain intervals throughout the day. The weekly binary options expire on Friday at 3 p.m.

Nadex determines the expiry value for most forex contracts by taking the midpoint prices of the last 10 transactions in the forex market, eliminating the highest and lowest three values, and then calculating the arithmetic average of the remaining four prices. It takes all midpoint prices acquired in the last 10 seconds of trade for high-activity names, cuts the top and lowest 30%, and averages the remaining.

Examples of Binary Options in Forex

To explain how binary options may be used to trade forex, use the EUR-USD currency pair. We utilize a weekly option that expires on Friday at 3 p.m., or four days from today (or Monday).Assume the current exchange rate is 1 EUR = 1.2440 USD.

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Consider the following scenarios:

1. You think the euro will not fall below 1.2425 by Friday and will remain above it.

The EUR/USD>1.2425 binary option is priced at 49.00/55.00. You spend $550 to purchase ten contracts (excluding commissions).The euro is trading at USD 1.2450 as of 3 p.m. on Friday. Your binary option settles at 100, earning you a $1,000 payment. Your overall profit (before commissions) is $450, or nearly 82%. If the euro had closed below 1.2425, you would have lost your whole $550 investment, resulting in a 100% loss.

2. You are negative on the euro and expect it will fall to USD 1.2375 by Friday.

The EUR/USD>1.2375 binary option is priced at 60.00/66.00. You would sell this option if you are pessimistic on the euro. As a result, the initial cost of selling each binary option contract is $40 ($100 – $60). Assume you sell ten contracts and earn $400 in total. Assume the euro is trading at 1.2400 at 3 p.m. on Friday.

You would lose the whole $400, or 100% of your investment, since the euro closed over the strike price of $1.2375 by expiry. What if the euro had finished below 1.2375, as predicted? In that situation, the contract would settle at $100, and you would earn a total of $1,000 for your ten contracts, representing a $600 or 150% profit.

Additional Basic Strategies

You do not have to wait until the contract expires to profit from your binary option deal.

For example, suppose the euro is trading in the spot market at 1.2455 on Thursday, but you are worried about the likelihood of a fall in the currency if U.S. economic data reported on Friday is highly favorable. In this example, your binary option contract (EUR/USD>1.2425), which was priced at 49.00/55.00 when you bought it, is now at 75/80. As a result, you may sell the ten option contracts you bought for $55 each for $75, earning a total profit of $200 (or 36%).

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You may also engage in a combination trade for a reduced risk/reward.

To demonstrate, consider the USD/JPY binary option. Assume your perspective is that volatility in the yen, which is now trading at 118.50 to the dollar, will grow dramatically, and it will move above 119.75 or below 117.25 by Friday. As a result, you purchase ten binary option contracts (USD/JPY>119.75, trading at 29.50/35.50) and sell ten binary option contracts (USD/JPY>117.25, trading at 66.50/72.00). As a result, you spend $35.50 to acquire the USD/JPY>119.75 futures and $33.50 to sell the USD/JPY>117.25 contracts (i.e., $100 – $66.50). The total cost for you would be $690 ($355 + $335).

By the expiry of options at 3 p.m. on Friday, three situations emerge:

  1. The yen is now trading over 119.75. The USD/JPY>119.75 contract pays $100 in this situation, whereas the USD/JPY>117.25 contract expires worthless. Your total payoff is $1,000, representing a profit of $310 (or around 45%).
  2. The yen is now trading below 117.25. The USD/JPY>117.25 contract pays $100 in this situation, whereas the USD/JPY>119.75 contract expires worthless. Your total payoff is $1,000, representing a profit of $310 (or around 45%).
  3. If the yen is trading between 117.25 and 119.75, both futures expire worthless, and you lose your whole $690 investment.

The Bottom Line

Binary options are a helpful instrument as part of a complete forex trading strategy, but they have a few downsides, including the fact that the upside is restricted even if the asset price rises, and a binary option is a derivative product with a fixed lifetime (time to expiration).

Binary options, on the other hand, offer a number of characteristics that make them particularly beneficial in the unpredictable world of currency. For starters, the risk is reduced (even if asset values jump), the collateral needed is little, and they may be employed even in flat, non-volatile markets. These benefits make forex binary options appealing to seasoned currency traders.

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