Trading Forex With Binary Options

Binary options are an alternative for engaging the foreign currency (forex) market. These options are yes or no wagers on short-term price movements in currency pairs. They are traded on the Nadex platform and as event futures through the Chicago Mercantile Exchange (CME). While you can find offshore binary options exchanges, they need not and mostly don't follow U.S. regulations. The Financial Industry Regulatory Authority is not alone among American financial watchdogs warning the public to avoid trading binary options on unregulated platforms. They often lure in customers by implying easy wins and a path to wealth, and if you should run into trouble with them, you're mostly out of luck in attempting to get your money back.

Using binary options is pricier than regular forex trading. Many brokers offer leveraged spot forex trades, which involve borrowing funds to amp up the potential gains. Of course, this also increases the possible losses. Forex binary options have fixed payouts, but they somewhat limit your risk. Your losses are capped in advance, which is not true with leveraged forex trading.

Defining Binary Options

Binary options have two outcomes: They settle at a fixed value (generally $100) or $0. Whether a "win" or a total loss occurs depends on whether the targeted asset value is above or below the strike price at 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 platinum is trading at $888 per troy ounce, and you are confident it will be trading above $900 later that day. You see a binary option on the metal trading at or above that price by that day's close, and this option is trading at $57 (bid)/$60 (offer). You buy the option at $60. If platinum closes at or above $900, as expected, your payout will be $100, meaning your gross gain (except fees) is $40 or 66.7%. On the other hand, if platinum closes below $900, you would lose your $60 investment, 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.

From the buyer’s perspective, the price of a binary option relates to the probability that the trade will be successful. Therefore, the higher the binary option price, the greater the perceived likelihood 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). The maximum risk for the buyer and seller is $100 in all cases.

Here’s the risk-reward profile for the buyer and seller in this example:

Buyer 

• Maximum risk: $35
• Maximum reward: $65 ($100 - $35)

Seller

• Maximum risk: $65
• Maximum reward: $35 ($100 - $65)

How Regulated Financial Exchanges Offer Forex Binary Options

Regulated financial exchanges offer forex binary options in a structured, transparent, and closely monitored environment to ensure fair trading practices and investor protection. These exchanges are subject to the regulations of financial authorities like the Commodity Futures Trading Commission (CFTC) in the U.S. Platforms like Nadex must follow financial, reporting, and conduct requirements to maintain their operational license.

Continual monitoring is conducted to detect and prevent manipulative and fraudulent trading practices, helping to ensure market integrity and trader protection.

The binary options at these exchanges are standardized contracts with set expirations and strike prices. This standardization facilitates clearer understanding and transparency for traders. In addition, a central clearinghouse guarantees the trades, which mitigates counterparty risk. This setup confirms that the contracts will be honored.

Moreover, real-time price quotes and historical data should be available, ensuring transparency in the pricing mechanism of binary options. On regulated exchanges, binary options risk and potential reward are known in advance, with the maximum loss for the trader being the initial investment option.

The exchanges should also keep the traders' funds in segregated accounts, separate from the exchange's operational funds, which protects the traders' capital should the exchange itself run into financial problems.

It should be noted that while forex binary options provide an opportunity for profits, they also carry a high level of risk and can result in the loss of all invested capital. Traders should ensure that they fully understand the risks involved and, if necessary, seek independent financial advice before trading.

Risks and Rewards of Trading Forex with Binary Options

Let's detail some of the risks and rewards in more detail:

Rewards

• Defined risk: One of the main advantages of forex binary options is the predefined risk. Traders know precisely how much they can lose or gain right from the start.
• Potential returns: Binary options offer the potential for significant returns, often ranging from 60% to 90% of the invested amount. This is much higher than typical returns seen in traditional forex trading.
• Simplicity: The binary options market is relatively straightforward, especially for newcomers. Traders predict whether the currency pair's price will be above or below a certain level at a specific time.
• Accessibility: Traders can access a wide range of currency pairs across global markets and trade them virtually around the clock in various time zones.
• Limited market exposure: Binary options have fixed expiries, and traders are not exposed to overnight risks such as significant after-hours economic announcements.

Risks

• Increased downside: The prospect of higher returns in binary options trading is invariably linked with increased risk. Traders should be acutely aware that they risk losing their entire investment if the binary option expires out of the money. This is why many places across the world, including the U.K., EU, and India, have banned binary options as simply another form of gambling.
• Market volatility: Forex markets can experience extreme swings, making it challenging to predict short-term movements. This volatility can be particularly risky for binary options, where the entire investment can be lost due to small, short-term market movements.
• Fraud: Regulators worldwide have scrutinized the binary options market, leading to strict regulations or even bans in some jurisdictions due to the high risk of loss and potential for fraudulent operators.
• Oversimplification: Traders should not be fooled. Binary options appear simple, but gamblers, not investors, leave their hopes to chance. Oversimplification can encourage traders to overlook the need for a thorough market analysis or even to trade impulsively.
• No ownership: Binary options trading does not involve buying or selling foreign currencies. Therefore, traders do not gain any rights to the underlying currencies.

Due to their high-risk nature, binary options are not suitable for all investors. Before trading binary options, conduct thorough research to ensure you understand the product, consider your risk tolerance, and, if necessary, seek advice from an independent financial advisor.

General Example of Binary Forex Markets

Binary options and event futures in forex are available from Nadex and the CME for the most popular pairs, such as USD-CAD, EUR-USD, and USD-JPY.

Tickets are offered with expirations ranging from intraday to daily and weekly. The minimum tick size on spot forex binaries is generally around 0.25, and the tick value is thus $0.25. The intraday forex binary options tend to expire hourly and as often as every five minutes, while the daily ones expire at set times throughout the day. Weekly binary options expire at 3 p.m. on Friday.

For most forex contracts, platforms calculate the expiration value by taking the midpoint prices of the last 10 trades in the forex market, eliminating the highest and lowest three prices, and taking the arithmetic average of the remaining four prices. For high-activity pairs, the exchange takes all midpoint prices collected in the last 10 seconds of trading to trim the highest and lowest 30% and average the rest.

Examples of Binary Options in Forex

Let’s use the EUR-USD currency pair to show how binary options can be used to trade forex. We use a weekly option that will expire at 3 p.m. on Friday, which for you is four days from now. Assume the current exchange rate is EUR 1 = USD 1.2440.

There are several possibilities:

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 $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 (excluding fees) is $450, or about 82%. However, if the euro closes below 1.2425, you would lose your entire $550 investment, a 100% loss.

2. You are bearish on the euro and believe it will decline by Friday 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 sell this option. Therefore, your initial cost to sell each binary option contract is $40 ($100 - $60). Suppose you sell 10 contracts and receive a total of $400. At 3 p.m. on Friday, 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 expected? In that case, the contract would settle at $100, and you would receive $1,000 for your 10 contracts, for a gain of $600 or 150%.

Basic Strategies

1) If the exchange allows non-European binary options, you do not have to wait until the contract expires to realize a gain on your binary option contract.

Let's say that on Thursday, the euro is trading in the spot market at 1.2455, but you are concerned about a decline in the currency if the U.S. economic data released on Friday is 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 bought at $55 each for $75 and book a total profit of $200 (or 36%).

The CME doesn't permit this kind of trading: once you buy an event future, you must hold it until expiry.

2) You can also combine trades for lower risk/lower reward.

Assume your view is that volatility in the Japanese 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. Therefore, you 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 would be $690 ($355 + $335).

There are three possible outcomes:

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 worthless, and you lose the full $690 investment.

The Bottom Line

Binary options can be useful tools in a comprehensive forex trading strategy, but the potential profits are limited even when the asset at issue moves in the direction of your bet. However, binary options have advantages that make them useful in the volatile world of forex. The risk is limited (even if the asset at issue changes dramatically in price), the collateral required is relatively low, and they can be used in flat markets that aren't volatile.