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
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:
- Maximum risk = $35
- Maximum reward = $65 ($100 - $35)
- Maximum risk = $65
- Maximum reward = $35 ($100 - $65)
Example of Binary Forex Markets: Nadex
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.
Founded in 2004, the North American Derivatives Exchange—or Nadex—is a Chicago-based financial exchange that specializes in short-term binary options and spreads. The company is a subsidiary of London's IG Group (LON: IGG) and is regulated by the Commodity Futures Trading Commission (CFTC). Binary options are legal and available to trade in the U.S., but only on a CFTC-regulated exchange like Nadex (you can also trade binary options through the Chicago Board Options Exchange).
Nadex binary options are offered with expirations ranging from intraday to daily and weekly. The minimum tick size on spot forex binaries from Nadex is 0.25, and the tick value is thus $0.25. The intraday forex binary options offered by Nadex expire hourly and as often as every five minutes, while the daily ones expire at certain set times throughout the day. The weekly binary options expire at 3 P.M. on Friday.
For most forex contracts, Nadex calculates the expiration value by taking the midpoint prices of the last ten trades in the forex market, eliminates the highest and lowest three prices, and then takes the arithmetic average of the remaining four prices. For high-activity names, it takes all midpoint prices collected in the last ten seconds of trading, trims the highest and lowest 30% and averages the remainder.
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. Therefore, your initial cost to sell each binary option contract is $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:
- 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 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.