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If you have experience trading options in the stock market, you may also be aware of trading options in the forex world. Forex (short for foreign exchange) is a trading market that is separate from the stock market, and is where traders buy and sell different foreign currencies.

Two parties might exchange currency if one is traveling in a different country, or represents a multinational company. Many people also trade foreign currency as an investment, just as traders 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, but comes with significant risk. Below, we’ll explore how binary options work and why one might choose to trade them.

What Are Binary Options?

Binary options are a type of options contract with only two possible outcomes: a fixed payout or nothing at all. Traders choose an underlying asset (such as a currency pair, stock index, or commodity), set a strike price, and select an expiration timeframe.

In binary options, both the buyer and the seller put down their money upfront. These 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.

What Are Forex Binary Options?

Forex binary options focus specifically on currency pairs, such as USD/EUR. These contracts are similar to other binary options but involve predicting whether a currency pair’s exchange rate will be above or below a chosen strike price at expiration. These are considered exotic options because they have a non-traditional payout structure and only two possible outcomes: either a fixed profit or a total loss.

How Do Forex Binary Options Work?

Unlike traditional call and put options, forex binary options have two possible outcomes: if the price of the currency pair is at or above the strike price at expiration, you make money. If it is below, you lose your investment. Each contract typically settles at either $100 or $0, depending on whether it expires in or out of the 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 minus 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:

Binary Option Risks and Rewards

Like all investments, investing in binary forex options comes with risks and rewards. These are different for the buyer and seller.

Risk for Buyers

Although 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 reward for a buyer purchasing a binary option is usually set at $100. If the currency is at or above the strike price at expiration, you will get the total amount of the contract.

Risk for Sellers

The risk for sellers of a binary forex option is known when the contract is agreed upon. Sellers of binary options must put their money down upfront, which is usually $100 minus the option price. 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

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.

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 options traders 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 must predict whether the price will be at or above the strike price at expiration, and within the specified timeframe.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

FAQ

Are forex and binary options the same thing?

The two terms are similar in that they both refer to trading on the foreign currency markets, but they are slightly different. Forex usually refers 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 form of speculative SoFi Invest®

SOIN-Q125-104

A bond option, like any option contract, gives the contract holder the right to buy or sell an underlying asset (in this case, a bond) at a specific price and time.

Although bond options are generally considered less risky than stock options, they still typically carry higher risk than more traditional investments.

Like all options, bond options are derivative securities, used by investors to bet on the direction of an underlying security. Understanding what bond options are and how they work can help you understand these risks and determine whether bond options make sense for your portfolio.

What Are Bond Options?

A bond option is a legal contract to buy and sell underlying bond assets, usually through a call option (the option to buy an underlying bond) or a put option(the option to sell a bond) at a specific price (known as the strike price), at or before a specific expiration date.

For example, an investor might purchase a bond call option with a strike price of $900. The level value (also known as “par value”) of the underlying U.S. government bond is $1,000. Let’s say market conditions push the value of that bond up to $1,100. In that scenario, the option holder has the right to buy the government bond at $900 — even as the value of that underlying bond now stands at $1,100.

Investors typically trade bond options on over-the-counter exchanges. Bond options on U.S. Treasury bonds can sometimes be found through specialized brokers or financial institutions that offer derivative products.

Pros and Cons of Bond Options

There are benefits and drawbacks to incorporating bond options in your portfolio.

Pros of Bond Options

Higher return potential. A well-executed options strategy can potentially increase a trader’s gains on a particular investment. Bond options can also be used to protect against downside risk. Investors often use bond options as a hedge against higher-risk investment strategies.

Risk hedging. Bond options investors can leverage derivative contracts to take advantage of interest rates and other short-term drivers of investment performance in the market. Investors can also lean on bond options to take advantage of pricing variations in options pricing, or to position their portfolios ahead of major geopolitical events (e.g., presidential elections, potentially big Federal Reserve policy decisions, or major recessions and other powerful economic forces).

Cons of Bond Options

The risk of unlimited investment loss. Although call options provide a buyer with the potential for unlimited gain if the underlying security rises in value, the seller of a call option faces the risk of unlimited potential loss, since the price of the underlying asset could theoretically continue to rise.

Should the underlying assets plummet to zero, the seller of a put option could face substantial loss, as they would lose the difference between the strike price and the asset’s zero value.

The risk of losing money quickly. As options are short-term investment instruments by nature, investors need to have extensive knowledge of near-term price movements and also be aware of the potential for loss when pursuing gains through options trading.

That means all options investors must master two key trading objectives — knowing the right time to purchase an options contract and knowing when to sell that contract, or cut losses by allowing the contract to expire without exercising the option to buy or sell by the expiration date. Although allowing an option to expire may sometimes be the best strategy, it can still result in the loss of premium and fees, which may add up over time.

Recommended: A Beginner’s Guide to Options Trading

Types of Bond Options

Bond options offer investors the right to buy or sell (via calls and puts) an underlying investment security at a specific time and at a set price.

Call Option Bonds

With a bond call option, if the price of the underlying bond rises, the contract holder (or buyer) can earn a profit by exercising the option to purchase the asset at a lower price and then selling it at the higher market price. A call option is in the money if the strike price is lower than the current market price of the underlying bond.

Conversely, the seller of a bond option hopes that the price of the bond stays below the strike price. If the bond price rises above the strike price, they would be required to sell the bond at loss for the lower strike price if the buyer exercises the option.

While a call option bond buyer stands only to risk the premium paid for the option, a call option seller, as mentioned previously, could face significant losses if the price of the bond rises significantly above the strike price.

Bond Put Options

While an investor who expects the bond’s price to increase might purchase a call option on that bond, an investor who expects the bond’s price to decrease might purchase a put option.

In this scenario, the holder is hoping the price of the underlying bond will fall below the strike price of the bond put option, so they can sell the bond for more than it’s worth, realizing a profit.

Conversely, bond put option sellers take on the risk that the bond’s price will decline. If the bond’s value falls below the strike price, the seller is obligated to buy it at a loss. However, their maximum loss is limited since a bond’s price cannot drop to zero like a stock.

Understanding Price Movements

Both of the above scenarios assume that the price moves in the direction the trader had hoped. What a bond investor strives to avoid is being on the wrong side of an options trade, selling below market rate or buying at an above-market rate.

For example, if an investor anticipates that bond prices will decline due to future market conditions, they may purchase a put option. If the face value of the underlying bond option were $1,000, a bond put option may give the contract holder the right to sell the option contract at the strike price of $900 — on or before the expiration date.

If bond prices fall, and assuming the underlying bond is now valued at $870, that bond option investor can still exercise the sale of the options contract at the strike price of $900, even though the bond’s value is lower. That can result in a profit for the investor.

Embedded Bond Options

Embedded bond options are features within certain bonds that grant either the bondholder or issuers specific rights under certain conditions. Examples of embedded bond options include:

•   Call options, which allow the issuer to redeem the bond before maturity

•   Convertible provisions, which allow the bondholder to convert the bond into equity

•   Floating-rate provisions, which adjust the bond’s interest rate based on changes in a benchmark rate

Callable Bond Options

Callable bond options come with an embedded call feature that allows issuers to redeem the bond before maturity at face value. These options are often used if the issuer expects interest rates to fall, which allows them to refinance at a lower rate.

Callable bond options offer flexibility, but they also face the risk of being called early. This prevents the investor from collecting interest payments against the full life of the bond.

Bond Options Pricing

Given all the variables, including the current price and future price of a bond, volatility levels, interest rates, and time to expiration, it can be very complicated to properly price a bond option.

Investors rely on several mathematical formulas for this, including the Black-Derman-Toy Model and Black’s Model (an elaboration of the well-known Black-Scholes model used for options pricing).

All of those options pricing models are complex, but they all rely on a few primary factors that determine the investment value of an options contract:

•   The market price of the asset that underlies the option (a.k.a. the spot price)

•   The current intrinsic value of the option

•   The time until the option expires

•   Volatility

For a bond option, interest rate movements are also a key determinant in pricing.

The Takeaway

Options traders may use a bond option as a hedge against economic volatility in key areas, such as interest rates and bond yield rates. Depending on your strategy, a bond option can be a useful portfolio management tool.

Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.

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