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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.
Binary Options
But first, what are binary options? They are options with a binary outcome, i.e., they either settle at a pre-determined value (generally $100) or $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, such as 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 US dollar today?
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.
Buyers and Sellers of Binary Options
For the buyer of a binary option, the cost of the option 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 – Maximum risk = $65
Maximum reward = $35 ($100 - $65)
Binary Options on Forex
Binary options on forex are available from exchanges like 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.
In the frenetic world of forex, how is the expiration value calculated? For forex contracts, Nadex takes 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. From December 15, 2014, for forex contracts, Nadex has proposed to take the last 10 midpoint prices in the underlying market, remove the highest three and lowest three prices, and take the arithmetic average of the remaining four prices.
Examples
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. Assume the current exchange rate is EUR 1 = USD 1.2440.
Consider the following two scenarios:
(a) 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.
(b) 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, if by Thursday, assume 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 US economic data to be released on Friday are very positive. 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. You therefore 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 – which is 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 contract, and $33.50 (i.e., $100 - $66.50) to sell the USD/JPY>117.25 contract. Your total cost is thus $690 ($355 + $335).
- 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%.
- 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%.
- The yen is trading between 117.25 and 119.75: In this case, both contracts expire worthless and you loss the full $690 investment.
Binary options have a couple of drawbacks: the upside or total reward is limited even if the asset price spikes up, and a binary option is a derivative product with a finite time to expiration. On the other hand, binary options have a number of advantages that make them especially useful in the volatile world of forex: the risk is limited (even if the asset prices spikes up), 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 trader who is looking to trade currencies.
