Sept 2, EURUSD spot vs. binary

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Sept 2, EUR/USD spot vs. binary

The yellow line is an incentive move from the Kumo – location is good, Momentum Band twisted, ADX turned trend & chikou is clear. The close of the blue Hammer is a good spot entry. A little consolidation into the Momentum Band is fairly likely though so it’s not a good binary bet.

Oval 1 is a possible level for a binary trade. It’s a rejection of the significant red candle at the spot entry & it’s a fake break of the tracks to it’s left. Oval 2 confirms the level nicely. The third candle in oval 2 and the three candles in the rectangle to it’s right are great binary spots. Price is very unlikely to move through that level without first testing the low or at least consolidating.

Trading Forex with Binary Options

Binary options are an alternative way to play the foreign currency (forex) market for traders. Although they are a relatively expensive way to trade forex compared with the leveraged spot forex trading offered by a growing number of brokers, the fact that the maximum potential loss is capped and known in advance is a major 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 on whether the price of the asset underlying the binary option is trading above or below the strike price by expiration.

Binary options can be used to speculate on the outcomes of various 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 example, say gold is trading at $1,195 per troy ounce currently and you are confident that it will be trading above $1,200 later that day. Assume you can buy a binary option on gold trading at or above $1,200 by that day’s close, and this option is trading at $57 (bid)/$60 (offer). You buy the option at $60. If gold closes at or above $1,200, as you had expected, your payout will be $100, which means that your gross gain (before commissions) is $40 or 66.7%. On the other hand, if gold closes below $1,200, you would lose your $60 investment, for a 100% loss.

Binary Option Buyers and Sellers

For the buyer of a binary option, the cost is the price at which the option is trading. For the seller of a binary option, the cost is the difference between 100 and the option price and 100.

From the buyer’s perspective, the price of a binary option can be regarded as the probability that the trade will be successful. Therefore, the higher the binary option price, the greater the perceived probability of the asset price rising above the strike. From the seller’s perspective, the probability is 100 minus the option price.

All binary option contracts are fully collateralized, which means that both sides of a specific contract – the buyer and seller – have to put up capital for their side of the trade. So if a contract is trading at 35, the buyer pays $35, and the seller pays $65 ($100 – $35). This is the maximum risk of the buyer and seller and equals $100 in all cases.

Thus the risk-reward profile for the buyer and seller in this instance can be stated as follows:

Buyer

  • Maximum risk = $35
  • Maximum reward = $65 ($100 – $35)

Seller

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  • Maximum risk = $65
  • Maximum reward = $35 ($100 – $65)

Forex Markets

Binary options in forex are available from exchanges such as Nadex, which offers them on the most popular pairs such as USD-CAD, EUR-USD, and USD-JPY, as well as on a number of other widely-traded currency pairs. These options are offered with expirations ranging from intraday to daily and weekly. The tick size on spot forex binaries from Nadex is 1, and the tick value is $1.

The intraday forex binary options offered by Nadex expire hourly, while the daily ones expire at certain set times throughout the day. The weekly binary options expire at 3 P.M. on Friday.

For forex contracts, Nadex calculates the expiration value by taking the midpoint prices of the last 25 trades in the forex market, eliminates the highest five and lowest five prices, and then takes the arithmetic average of the remaining 15 prices.

Examples of Binary Options in Forex

Let’s use the EUR-USD currency pair to demonstrate how binary options can be used to trade forex. We use a weekly option that will expire at 3 P.M. on Friday, or four days from now (or Monday). Assume the current exchange rate is EUR 1 = USD 1.2440.

Consider the following scenarios:

1. You believe the euro is unlikely to weaken by Friday and should stay above 1.2425. The binary option EUR/USD>1.2425 is quoted at 49.00/55.00. You buy 10 contracts for a total of $550 (excluding commissions). At 3 P.M. on Friday, the euro is trading at USD 1.2450. Your binary option settles at 100, giving you a payout of $1,000. Your gross gain (before taking commissions into account) is $450, or approximately 82%. However, if the euro had closed below 1.2425, you would lose your entire $550 investment, for a 100% loss.

2. You are bearish on the euro and believe 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 are bearish on the euro, you would sell this option. Your initial cost to sell each binary option contract is, therefore, $40 ($100 – $60). Assume you sell 10 contracts, and receive a total of $400. At 3 P.M. on Friday, let’s say the euro is trading at 1.2400.

Since the euro closed above the strike price of $1.2375 by expiration, you would lose the full $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 would receive a total of $1,000 for your 10 contracts, for a gain of $600 or 150%.

Additional Basic Strategies

You do not have to wait until contract expiration to realize a gain on your binary option contract. For instance, let’s say by Thursday the euro is trading in the spot market at 1.2455, but you are concerned about the possibility of a decline in the currency if U.S. economic data to be released on Friday are very positive. In this case, your binary option contract (EUR/USD>1.2425), which was quoted at 49.00/55.00 at the time of your purchase, is now at 75/80. Therefore, you could sell the 10 option contracts you had purchased at $55 each, for $75, and book a total profit of $200 (or 36%).

You can also put on a combination trade for lower risk/lower reward. Let’s consider the USD/JPY binary option to illustrate. Assume your view is that volatility in 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, therefore, buy 10 binary option contracts (USD/JPY>119.75, trading at 29.50/35.50) and also sell 10 binary option contracts (USD/JPY>117.25, trading at 66.50/72.00). Therefore, you pay $35.50 to buy 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 would be $690 ($355 + $335).

Three possible scenarios arise by option expiration at 3 P.M. on Friday:

  1. The yen is trading above 119.75. In 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%).
  2. The yen is trading below 117.25.In 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%).
  3. The yen is trading between 117.25 and 119.75: In this case, both contracts expire worthlessly and you lose the full $690 investment.

The Bottom Line

Binary options are a useful tool as part of a comprehensive forex trading strategy but have a couple of drawbacks in that the upside is limited even if the asset price spikes up, and a binary option is a derivative product with a finite lifespan (time to expiration).

However, binary options have a number of advantages that make them especially useful in the volatile world of forex. For starters, the risk is limited (even if the asset prices spikes up), the collateral required is quite low, and they can be used even in flat markets that are not volatile. These advantages make forex binary options worthy of consideration for the experienced currency trader.

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Binary Options vs. Vanilla Options in Forex Trading

According to my last year’s poll about 15% of this blog’s readers use binary options and in their currency trading. 15% also use other types of financial options to trade Forex. Although it is not much compared with the popularity of the spot market, the options can be very useful in portfolio of every trader. However, there are two problems when dealing with online options trading industry:

  • The majority of online Forex traders lack basic understanding of the financial options concept.
  • The binary options have a very poor reputation thanks to many brokers acting like they are online casinos with attitude.

The first problem will be addressed here by explaining the basics of binary and vanilla options and their main difference. The second problem cannot be addressed by me alone, but I can start by introducing vanilla options and manageable binary options as a viable alternative to gambling opportunities that most popular BO brokers actually offer.

What are options and why traders need them?

Vanilla options are financial contracts that entitle a right to buy or sell a specific asset at a particular price (called strike) on or before an agreed time/date. An example of a call option (bullish) is a contract for a right to buy 1 lot of EUR/USD at 1.4000 (assuming current rate of 1.3670) on December 31, 2020. If you buy such an option, you are betting on significant EUR/USD uptrend during the next year. Your gain on the strike date is calculated as X — 1.4000, where X is the EUR/USD rate on December 31, 2020. For the sake of example, let us consider that it reaches 1.4221. Your end gain is 1.4221 — 1.4000 or 221 pips or $2,210. Depending on the price you paid for this call option, you can calculate your total profit or loss. E.g. if you paid $1,000 for it, your total profit would be $2,210 — $1,000 = $1,210.

You might be asking — what is the point of buying such an option when you could make 551 pips (1.4221 — 1.3670) buying 1 lot of EUR/USD on spot Forex? Because your risk is limited with a call option. If you buy 1 lot of EUR/USD, your risk is virtually limitless. Of course, you would apply a , but then it would not be the same trade as using a call option as the latter would not be negated if a price were to reach some deeply unfavorable rate during the holding period. If you are buying a call option instead of a spot, your risk is always fixed.

Let us look at an example of a losing vanilla option trade but now with a put option (bearish). You anticipate a weakness in EUR/USD and decide to buy a put contract on 1 lot of EUR/USD with a strike rate of 1.3500 (the current rate is the same 1.3670) on December 31, 2020. You pay $1,500 for this contract. The year 2020 ends at the same 1.4221 rate as in our previous example. Obviously, your put option does not yield any profit — you will not exercise your right to sell EUR/USD at 1.3500 when the current rate is 1.4221, wouldn’t you? So, your only loss is the price you have paid for the option — $1,500. If you have used a spot trade in this situation, you would have lost 1.4221 — 1.3500 = 721 pips or $7,210.

American and European style options

Vanilla options come in many styles, but the most popular are two of them: American and European. American options can be exited or, simply telling, sold before the expiration time. You might decide to exit a call option to cut your loss if you see that the currency pair is poised to move down. Or you might want to sell a contract when the underlying rate moves in your favor, but you need some cash. In this case, you earn the profit, which is a difference between the price you sold your option for and the price that you have paid for it. In the examples above, you could have sold your call or put contract before December 31, 2020, if you were buying options.

European options cannot be sold before the contract’s expiry date. In the examples above, you would not be able to sell your European options before December 31, 2020. Obviously, European options for the same underlying asset, same entry and strike price and same expiry date should always be valued cheaper or equally to American options. If you are focusing on Forex trading, you will probably never deal with European options as currency options are rarely traded in European style.

Binary options

Binary options are not vanilla options. They are exotic style options as they are neither American nor European. The main difference between the binary and the vanilla options is the fixed outcome of the former: you get a fixed ROI on the contract’s price if option ends . This means that binary options have a fixed gain in addition to a fixed loss, which intrinsic to vanilla options. While it can be limiting to your potential profit, it also means that you can potentially earn more than vanilla option would offer in some situations.

Additional difference stems from the current trend in the online binary trading industry — usually brokers award option expiration with some minor reward (5–15% of the original option price). It can be a nice consolation if you happen to lose your binary option bet, but you should understand that this award is created by cutting the maximum award with the same broker.

How to use options to your advantage?

Getting right platform

Despite their disadvantages and apparent difference from the traditional spot Forex trading, both vanilla and binary variants can be used as an auxiliary tool by common retail traders. If you follow my blog, you should have probably read my case study for using a spot FX trade to hedge a binary options trade. There are other ways to combine spot and options, but to do that you have to choose your broker carefully.

First thing to do is to avoid binary trading brokers with inflexible strike prices and times. It is also a bad idea to trade with a binary options providers that forbid exiting a trade before the expiry of the option. Flexible contract size is also a very important property for successful combination of binary and spot trading. If your broker lacks all of the , you can still try trading with it, but I would say that your chances for success are significantly crippled with such companies.

Second, the best binary brokers offer not only standard call/put but also such important option types as “touch”/”” and “in”/”out” as they are very useful in exercising trade based on volatility (which is nearly impossible to do in spot market).

Third, going with a vanilla options broker (like Interactive Brokers or ) should be your preferred choice. Unfortunately, with companies offering vanilla options trading, it is still true that the better their conditions and platform the more difficult it is to set up an account with them. You would need at least $10,000 to open an options trading account with Interactive Brokers and also pay for price feed subscription, but you would get an exceptionally powerful options trading platform. With , starting is much easier (who would have thought!), but their product is less sophisticated and would not satisfy professional participant of options market. You can also try vanilla options for free using our platform.

Combining spot and options FX trading

There is a number of ways to enhance your overall trading performance using different kinds of options. Here is a short list of some such methods:

  • An earlier mentioned method for hedging a option on spot FX market.
  • Binary options can be used to trade on your ideas of the future market volatility. For example, even simple uncovered sale of the normal call and put options can be used to bet on decrease in volatility.
  • trades are probably safer in options than in spot. When you bet on behavior, you normally want to avoid using because it may prevent your trade from maturing. On the other hand, trading spot market without can be very risky. This is where buying a call or a put would do the trick for you.
  • You can use data from your options platform to analyze the current market sentiment. Higher values for certain strike prices usually mean higher probability of moving towards those levels.

I would like to finalize this overview post with a poll to find out the current preferences of this blog’s readers.

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