How you manage risk as well as how and where you place the proper “Stop-Loss” settings are two of the most difficult aspects for Forex traders to master. Trading Binary Options in the Forex market offers an effective way on how you’re able to take advantage of the opportunities which market volatility creates when attempting to control risk.
Even under normal market conditions when fundamental news announcements are issued by governments, major corporations or central banks, including the overall volatility of the markets which were created over the past year, it’s extremely difficult to be able to accurately gauge the risk factor of any trade.
For Example, lets say there is “market shock” on a fundamental news announcement by the Employment Cost Index (ECI), when the report was significantly higher that what anyone expected. So as a result of the news report, the market not only becomes volatile and spikes rapidly, but it also makes a gap of almost 150 pips (1.3130-1.3280) in the EUR/USD currency pair.
Unfortunately, this spike caused a lot of the currency traders, even those who were trading technically correct, like placing a proper stop-loss, to get bumped out of the market for that particular trade. In some of the cases, some traders even lost more than what they had in their trading accounts because of the gap, leaving them with an outstanding negative balance and debt to their Forex brokers. Yes, this does and can happen.
Another example of what some Forex traders will commonly face is one that can especially be frustrating to new currency traders. Right after they click on the Buy/Sell button activating the trade, the market suddenly makes a quick 50 to 70 pip jump which goes against their position, and as a result stops them out with a loss.
Also, most often, the market will then correct itself and it will move back into it’s original direction of the trade, one which you would have made a profit. But this doesn’t matter since you hit your “Stop-Loss” and thus kicked you out of the trade. This is a natural occurrence when Spot Forex Trading in any volatile market such as the currency market, and is frustrating as well as costly.
Spot Forex Trades Or Forex Binary Option Trades
For this very reason, there are now a lot of traders of varying experience who are transitioning towards better Managing their Risk by trading the Forex market via binary options. They do so as a complement to their Spot Forex trading since doing so will provide them with an alternate trading instrument where they are able to take advantage of the opportunities which market volatility can create while controlling trade risk.
Some traders are however intimidated just by hearing the term “binary options,” but there’s really no reason why there should be. Trading Binary Options in the financial markets are not exotic derivatives, nor are they any other complicated instruments, but are actually extremely easy to understand.
Binary options are considered binary, which means “two” since there are only two possible outcomes of a Forex trade as they approach expiration, which is 0 or 100. Perhaps the most easiest definition of binary options may be in terms of “true” or “false” statements.
If the actual event that you speculate occurs, then it’s (True), the binary option then settles at 100. If that same event doesn’t happen, then it’s (False), thus the binary trade will settle at zero (0).
A Forex binary options trade can be termed as: EUR/USD to be above the mark of 1.3380 at expiration. The price of a binary option, between 0 and 100, can be seen as the probability that the event will occur.
One of the most important characteristic of a binary options trade is that the trader doesn’t have to wait for the actual expiration of the trade to close it out. So say you decide to purchase a Forex binary option trade at 35 points, and then it happens to move up to 70 points, you’re able to close out that trade at that level for an 35 point ($350) profit gain. 70 – 35 = 35 points.
Another important advantage which helps in money management when trading binary options is that the trade cannot lose more than the option purchase price. So if you guess wrong on a particular binary options trade, and the market decides to move against you, the maximum dollar amount that you can lose is the original 27 point buy, regardless of how far that underlying market moves against your position.
The Benefits Of Trading Binary Options
Full Margin Instrument
Traders cannot lose any more $$$ than what they have in their actual trading account. The trader is only responsible for the exact dollar amount of risk when a trade is placed. You can potentially end up with a negative amount when Spot Forex trading.
No Stop-Loss Issues
Since the high/low level is already established, traders do not have to worry about placing stop-loss or potentially being stopped out of the market on a suddenly volatile market move against your position. It also gives the trade time for it to correct itself and potentially make it profitable.
The Capital Risk Is Lower
In most cases, traders entering a binary options trade can do so without risking a lot of capital than trading a straight Spot Forex trade. This is especially important when trading longer time frames.
Applying A Forex Binary Trade On The EUR/USD Currency Pair
This is to illustrate a Forex Binary Option trade strategy and how it can be employed. This was based on a real world trading example based on the EUR/USD currency pair.
Note there was caution regarding making a Spot Forex trade on this particular pair since there was potential volatility that surrounded an European Central Bank (ECB) announcement, and there was implied risk as a result. There was speculation from the market participants regarding this fundamental announcement, that the Euro would rally.
Trade Binary Options or Spot Forex?
Looking at this 5 minute chart, you just made a Spot Forex trade on the EUR/USD currency pair. You have risked the potential of possibly losing 57 pips or ($570) trading one standard Forex contract.
If you would of made a Forex binary option trade however, your risk would of only been 31 points or ($310) on the same Forex contract.
(This is assuming that you hit your Stop-Loss)
If you analyze the chart on Figure 1, It was expected that there would be support around the 1.3338 level (Point A), and consequently, there were a few ways to potentially trade this pair:
Option #1, Based on a Spot Forex Trade:
When the price potentially confirmed the support level, the entry point of this trade would of been around the neighborhood of 1.3347 or so (the Green line). The Stop-Loss placement was put directly below the previous support level (Point B), just in case a double bottom scenario developed.
So in this case, the Stop-Loss would of been entered at 1.3290, which would of resulted in a potential “risk” loss of 57 pips ($570) on a standard contract, or potentially more if the market happened to gap over the Stop-Loss.
Option #2, Based On A Forex Binary Options Trade:
Once the binary strike prices were reviewed, it presented a few different choices. The binary options that we were looking at had three different strike prices based on the same EUR/USD currency pair.
• over 1.3350
• over 1.3370 and
• over 1.3390
The 1.3350 point as well as the 1.3370 points were discarded since the Buy Prices happened to be over 35, and we have a rule never to trade any binary which is priced between 35 and 65. This is because of the risk and reward implications that it presents. The third option, the 1.3390 strike was priced at 28/31 (Sell/Buy). This looked like our most attractive and best trade. If this option trade was placed, the total risk of loss, even if the underlying happened to gap 150 pips against our trade, was set at 31 points ($310) on the same equivalent standard Forex contract.
A Binary Options Trade Strategy.
If you would have placed a Spot Forex trade order, the trade would have been stopped in a matter of just mere minutes because of the volatility cause by the fundamental ECB announcement. If you would have placed a binary options trade however, you wouldn’t be concerned about placing a Stop-Loss since a stop has already been automatically established and built into a binary of 0 and 100. In this case, the loss would be set at $310 and not a penny more regardless of what the market did.
After considering the market conditions as well analyzing the risk, the binary options trade would obviously be the best choice. The trade offered the opportunity of taking advantage of the potential volatility of the ECB announcement. It provided absolute zero risk of being stopped and getting knocked out of the trade by a swift volatile move.
The binary options trade also providing security so even if the market happened to gap against our position, the maximum loss would of still have been 31 points. The overall risk of making the binary options trade was 46% less than what was offered on the Spot Forex trade position.
Figure 2 shows the result of placing the Spot Forex trade, and how that trade would of been stopped out almost instantly because of the sudden swing down in the market.
Because we chose the binary options trade, there was no worry regarding being stopped out and getting kicked out of the trade. We knew our maximum loss would be $310 and it also allowed us the the opportunity for the EUR/USD to correct itself (which it often does after a major fundamental announcement) and move in favor of our direction.
To illustrate how the binary price worked out on this particular trade, note the various price levels along with the Sell/Buy prices for this particular binary option on the EUR/USD pair, to be greater than 1.3390.
So even if we had sold this binary trade once it reached it’s extreme low point when it was spiking down, the loss would have been just 13 points, which is the difference between the Buy which was at 31 and the Sell which was at 18.
Since there was still some “time” that was remaining until it expired, this particular option still had some value. Also, looking at the chart in Figure 2, it shows that there are two points which this binary was priced at 75/78. Keep in mind that the first point however had a much higher underlying price.
This may seem a bit confusing initially, but it’s really pretty much straightforward. The price essentially reflects the probability of a certain event happening.
Even though the first price was higher, there was however still some significant time for the currency pair to turn against the position.
The second price was a lot closer to the strike price, but since there was less time for the currency pair to move adversely, the probability would of been just as great that the binary trade would of closed above the strike price as it was at the peak. As a result, the binary closed at 100/100.
In the Spot Forex market trade, it would have hit the stop-loss, with a loss of $570 and the trade would have lasted just a few minutes. But going back to the binary trade, even if we happened to of closed it out at the worst possible point, the maximum loss would have been 13 points or $130.
If the binary option would have been held to expiration, the profit would have been 69 points, which is the difference between the buy order, which was at 31 and the settlement which was at 100, so 69 points or $690. As it happened, we sold out this trade when the market decided to turn back from its high and sold out at 73, which was a 42 point or a $420 profit. 73 – 31 = 42 points
Binary Options Trading Terminology
Binary Options: which is also known as fixed return options or digital options, are options in which the payouts are determined at the beginning or onset of the contract. It will then pay a fixed amount of profit if the option happens to expire when in the money, regardless of how much the price of the underlying asset decides to move
Underlying Asset: is the currency pair, a commodity, stock or indice or any other other financial asset which constitutes the basis for creating an option
Call Option (Up): an option which gives the trader a profit when the underlying asset happens to increase in price, this compared with the level which it was purchased at
Put Option (Down): an option that gives the trader a profit when the underlying asset happens to depreciate relative to the purchase level
Strike Price: The specified price of the binary option
In The Money: the spot price of the underlying security happens to be in a favorable profit position relative to the strike price of the binary options contract
Out Of The Money: the spot price of the underlying security that’s not currently in a favorable position relative to the strike price of the binary options contract
Controlling Risk In Volatile Markets
Binary options provides the trader with the opportunity of participating in volatile markets while still being able to manage risk to a higher degree than what’s offered by a traditional Spot Forex trade. So abide by the general rule of trade losses. If you manage your losses correctly, the profits will then take care of themselves.
Binary options are also priced for a variety of different financial markets as well, including the futures market, equity indexes, and of course the foreign exchange or Forex market.