If you have experience trading options in the stock market, you may also be interested in trading options in the forex world. Forex (short for foreign exchange) is a trading market separate from the stock market where traders buy and sell different types of foreign currency.
Two parties might exchange currency if one is traveling in a different country or part of a multinational company. Many people also trade foreign currency as an investment, just as people do with the stock market.
Binary options, also known as digital options, are one way to trade in the foreign currency market. This all-or-nothing investment option can be attractive to some traders. Below, we’ll explore how binary options work and why one might choose to trade them.
What Are Binary Options?
Binary options are one of the more exotic options out there. With a binary option, you set a currency pair (like USD/EUR), a strike price, and a timeframe. Both the buyer and the seller put down their money upfront. Binary options are typically priced from 0 to 100, and the price represents the approximate probability that the given currency pair will be at or above the strike price when the option expires.
How Do Forex Binary Options Work?
Unlike traditional call and put options in the stock market, forex binary options have only two possible outcomes: if you’re on the right side of the strike price, you make money, and if you’re on the “wrong” side of it, you lose money.
For example, if an option is priced at 40, then the buyer must pay $40 per contract and the seller must pay $60 ($100 – the $40 price) upfront. When the option closes, whichever side is on the right side of the strike price collects the entire $100. The fact that there are only two possibilities leads to the name binary option.
Pros and Cons of Forex Binary Options Trading
Here are some of the pros and cons of trading binary options when forex trading:
| Pros | Cons |
|---|---|
| Limited and defined risk | More expensive than traditional forex trading |
| Can trade even with a smaller budget | Supported by a limited number of brokers |
| Easier to understand since there are only two possible outcomes | Even as a seller, you must put your money down upfront |
| 100% loss of your position if you are wrong |
Binary Option Risks and Rewards
Like all investments, investing in binary forex options comes with risks and rewards. These risks and rewards are different for the buyer and seller.
Risk for Buyers
While there is risk in trading binary options, a trader knows the amount of money they’re risking upfront. With a binary option, you put down a specific amount of money (the option price). If the currency is below the strike price at expiration, you will lose all of the money you put down.
Reward for Buyers
The potential rewards for a buyer purchasing a binary option are set when the option contract is set. If the currency is at or above the strike price at expiration, you will get the total amount of the contract (usually $100).
Risk For Sellers
The risk for sellers of a binary forex option is known when the contract is agreed upon. Unlike sellers of traditional options in the stock market, sellers of binary options must put their money down upfront. This is usually $100 minus the price of the contract. If the option closes at or above the strike price, the option seller will lose all of the money they put down.
Reward for Sellers
On the other hand, if the currency closes below the strike price at expiration, the option will expire worthless and the seller will collect the entire $100. This could be a significant percentage gain, depending on how much was put down originally.
Binary Option in Forex Examples
Here are a few examples of how you could use a binary option in forex trading:
• EUR/USD binary option for 1.15 closing in one hour, trading at 30. A buyer would need to put down $30 and the seller $70, per contract. If the price of Euros is at or above 1.15 dollars in one hour, the buyer will collect $100. Otherwise the seller will take $100.
• AUS/JPY binary option for 83 closing next Friday, trading at 75. A buyer would put down $75 and the seller of this option would put down $25 per contract. If the price of the Australian dollar is at or above 83 yen, the buyer would take $100. If it is below 83 yen, the seller would collect the entire $100, minus commissions.
The Takeaway
Binary options are a way to invest in the foreign currency market. At its simplest, a binary option is a bet on the ratio of two different currencies. With a binary option, both the buyer and seller put down their money upfront. At expiration, whichever side is on the correct side of the strike price collects the entire premium put down (usually $100 per contract). Binary options can be incredibly risky because you have to be right on the direction of the move, the magnitude and the timing.
To guide your options trading platform, it can be helpful to use a platform like SoFi that offers educational resources about options. What’s more, SoFi’s options trading platform has an intuitive and approachable design that gives investors the ability to make trades from the mobile app or the web platform.
FAQ
Are forex and binary options the same thing?
If you are comparing options vs. forex, you may be wondering what the difference is between forex and binary options. The two terms are similar in that they both refer to trading on the foreign currency markets, but they are slightly different. Forex refers usually to buying and selling the actual currency itself, while binary options allow you to invest in forex for a smaller budget with more leverage.
Are binary options better than forex?
Binary options are a particular kind of currency option that have only two possible outcomes. They come with their own set of risks and rewards. Which one is better will depend on your personal risk tolerance and knowledge of the foreign currency markets.
Can you trade binary options on forex?
Yes, binary options are typically traded in foreign currency pairs (like EUR/USD or AUS/JPY). Binary options give you an additional way to speculate or trade on movements in the foreign currency markets.
Photo credit: iStock/simonapilolla
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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