The forex market is the largest of the world markets, so it offers a wide pool of tools that one can use to speculate on various financial instruments. Contrary to perception, trading is not limited to speculating on the price difference. Instead, binary options offer an alternative way of profiting from the trillion-dollar marketplace at the lowest risk.
What are binary options?
Simply put, they are financial instruments that come with two pay-off possibilities when it comes to settlement.
In most cases, one gets to walk away with a fixed amount or nothing at all at expiry. The basic idea behind these instruments is that they require one to make a call on whether the underlying price of an asset will be above a given price point after a set period or not. One can also speculate on whether the price will be below a given level.
Binary options offer an alternative way of speculating on the underlying security price rather than entering a long or a short position in anticipation of price moving higher or lower to profit from the price difference.
For instance, they are commonly used to speculate whether the S&P 500 will rise over a given level over one week or even a month. Additionally, they can be used to speculate whether the Non-Farm Payroll will be higher or lower than what the market expects.
They are relatively expensive tools for trying to profit from in the currency market. However, given that the amount of risk exposure is known in advance and capped, it makes them ideal for anyone looking to keep risks low.
Additionally, they are legal and available to trade in the US through exchanges. However, they are only issued by CFTC regulated exchanges.
Example
Consider oil opened the week at $72 a barrel. An investor who is confident that the prices could close the week at $74 a barrel could use binary options to try and profit from a possible price rally.
In this case, the person can buy the option trading at, say, $40 (bid)/$45 (offer). By purchasing at $45, they will make a profit of $100 per contract on oil prices, closing the week at or more than $75 a barrel. Consequently, the gross gain will be $55 ($100-$45)
However, should the oil price close below the $75 mark, one will end up with a net loss of $45 per contract paid, translating to a 100% loss.
Buyers vs. sellers
While buying a binary option, the cost incurred is the value at which it is exchanging. For the seller, it is a completely different story as it is the price minus $100. Consequently, a buy position translates to a probability that the given trade will come into fruition. The higher the bill, the increased prospects of asset price appreciation.
It is also important to note that both sellers and buyers must put a cap on their trades at any given time. For instance, if an option is pegged at $40, a buyer will only pay $40 while the seller will only pay $100-$40.
In this case, a buyer’s maximum risk is $40 while the maximum reward is $100-40, which is $60. In the case of sellers, the maximum risk is $60, and the maximum reward is $40.
Example
Let’s assume the current EURUSD exchange rate is 1.2240. Using a weekly option, a trader expects the exchange rate to appreciate 1.2300. If the binary option for EURUSD is quoted at $53/$57, the person could buy ten contracts for a total of $570 ($57 X10).
If by Friday the exchange rate has risen to 1.2400, it will settle at $100 a contract, meaning he will walk away with $1000 ($100 x 10). The gross gain, in this case, will be $430 ($1000-570).
However, if the exchange rate tanks to 1.2200, one will incur a net loss of $570 which is the actual amount placed in the option in the first place.
Example 2
Consider an investor confident that EUR/USD will tank below 1.2400 by the end of the week. If the option is quoted as $50/$56, the trader will sell. The cost for each contract will be $100-$50= $50. Assume the person sells ten contracts the total cost of the trade will be $500 ($50 x10).
Suppose that by Friday, the EUR/USD exchange rate has risen above 1.2400 to say 1.2450, the investor will incur a loss of $500 as the exchange rate did not drop.
However, if the exchange rate fell below 1.2400 to say 1.2375, the contract will settle for $100 for each contract. In this case, the investor will end up with a profit of $1000 ($100 x 10) as each contract is priced at $100. The gross gain, in this case, will be $500 ($1000-$500)
What you should remember
While trading binary options, it is important to note that it is not a must to settle a contract at expiry to realize the profit.
A binary option of EURUSD is quoted at $50/$55 and is expected to rise above 1.2400. If a person buys ten contracts at the start of the week for $550 but comes Wednesday, the exchange rate has risen to 1.2450; one can opt to settle rather than wait until Friday as initially agreed.
However, by Wednesday, the binary option charge could have risen to $70/$75. In this case, you will have to sell the ten contracts initially bought at $55 for $70, translating to $700 ($70 x10), consequently book a profit of $200 before expiry.
Conclusion
Binary options are high-profile financial instruments for traders who want to keep their risks low while trading the financial markets. The tools can be applied to any security.
They stand out because their risk exposure is quite limited, and the fact that they can be applied on markets with low volatility where massive price gains are not a must. However, they are quite complex and require an in-depth understanding for one to make a fortune while trading them.