Binary option trading is a relatively new development in the retail trading world. Five years ago, no one had even heard of it.
Since 2012 however, the popularity of binary options surged as a result of aggressive marketing by binary option brokers, and the promotion of binary trading software by the trading “gurus”.
Right now, interest on the topic continues to grow at record levels:
Popularity of search term “binary options” in Google
Given its current popularity, binary options are likely to be the first “asset” that beginners start trading with.
However, just because something is new and popular… doesn’t mean it’s worth doing. (Who remembers the fuss over bitcoin trading?)
Popularity of search term “bitcoin trading” in Google
Opportunities come and go all the time in the retail trading space… and it’s important for us to tell the difference between sustainable business models and short-lived fads.
So let’s take a moment to examine binary options, and see if it’s something we should be paying attention to.
But before we do that, let’s first take a quick look at traditional (i.e. vanilla) option contracts.
Vanilla Forex Options
Traditional option contracts were initially introduced for people to hedge against future uncertainty. (Learn the basics of how it works here.)
For example, a German company selling cars in the United States would worry about high EUR/USD exchange rates in the future.
Because then they would be getting revenue in a weaker currency (USD) while having to pay expenses in a stronger currency (Euro) in their home country. This results in a significantly lower net profit, or even worse, a net loss.
Forex option contracts were thus introduced to solve this problem, as any losses stemming from currency fluctuations could be offset by profits made from buying options contracts.
To continue with the example, the German car company may choose to buy EUR/USD call options, which would profit from an increasing EUR/USD rate. Thus, any operational losses in the future (due to a high EUR/USD rate) can be offset by the profits gained from those option contracts.
This is, and continues to be, the main purpose of Forex option contracts.
Now of course, in order for the German company to buy call options, someone has to be willing to sell it to them.
Perhaps, a financial institution in France does not believe that the EUR/USD will continue to strengthen over the next 12 months, and so is willing sell call options to the German company.
(This, by the way, is how financial markets work. Participants have varying views of the future, and so trade against each other in line with their own expectations.)
In this transaction, the German company pays a fee (in buying call options) to protect against future currency risk, while the financial institution gets paid to take on that risk.
- The German car company looks to limit future currency risk by buying call options
- The financial institution (or speculator) collects a fee from selling call options and assumes the currency risk
- Option buyers pay a fixed fee for the potential of a very large profit
- Option sellers collect a fixed fee for the potential of a very large loss
Forex Binary Options
In a vanilla option trade, the buyer does not know in advance the amount of money he stands to win. Similarly, the seller does not know in advance the amount of money he stands to lose. The amount is ultimately determined by how far the market price moves.
In a binary option trade however, the trader will know in advance the exact amount he stands to win or lose, before taking the trade. Binary options are named as such because there are exactly only two possible outcomes: you either win a fixed amount, or lose a fixed amount.
Binary options ask a simple question: will the price be above [price level] at [time]?
For example: will the EUR/USD be above 1.3000 at 4.30pm? If you think so, you buy the binary option. If you don’t, you sell.
That’s pretty much all there is to binary options.
Upside of Binary Options
As you can see, binary option trading can be simply explained and is easily understood. This is a big benefit to new traders, as they can quickly learn the basic mechanics and start trading right away.
A related benefit of this, is having to make fewer trading decisions.
In spot forex trading, for example, one has to decide:
- Where and when to enter the market
- The appropriate trading lot size to use
- How to manage the trade
- Where and when to close the trade
In binary option trading however, there are only 2 decisions to make:
- Whether the market price will be above a certain price level at a certain time
- How much to risk on the trade
As such, binary options offer a much simpler trading process. You don’t have to think about (or calculate) leverage and margin at all.
And, since the potential loss on each trade is fixed, you will never get a margin call.
Lastly, options offer traders the unique ability to make money by predicting where prices will not go. (This goes for all types of options, not just binary options.) This can’t be done in the spot Forex market.
So… does binary option trading sound good?
Sure it does!
Well… at first glance, anyway.
Now let’s take a look at the downsides of binary option trading. These are the things your binary option broker won’t tell you.
Downside of Binary Options
The most obvious downside of binary option trading is the lack of flexibility.
For example, if the market price moves even one pip against you upon option expiry, you’ll lose your entire stake. You can’t choose to defer your trade exit under any circumstances.
Also, with some binary option brokers, you can’t change your mind and close or modify a trade before expiry. In this sense, a binary option trade is typically an all-or-nothing proposition.
These points on inflexi