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).
Three possible scenarios arise by option expiration at 3 p.m. on Friday:
- 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.
The Bottom Line
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.
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