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One of the most interesting and potentially valuable developments for traders is the emergence of binary options as an accessible tool. Binary options are part of a class of options known as exotics, though in reality they are quite simple as they expire at all or nothing and can provide traders and investors a powerful mechanism for reducing risk.
Binary options have components common to regular, "plain vanilla" options, such as: an expiration date, a strike price, and a premium for putting on the position. They differ from regular options, however, by providing traders with a fixed payoff. The payoff is $0 if the price doesn't hit the strike price by the expiration time, or a fixed amount, (i.e., $100) if the price does hit the strike price. For the forex trader, the North American Derivatives Exchange (Nadex) now offers binary forex options for the EUR/USD, GBP/USD, USD/CAD, USD/CHF and USD/JPY. Nadex offers intraday, daily, and weekly expirations. There are a broad range of potential uses of binary options, including a simple directional play, news event trading or creating hedges. And binary options with hourly strikes generates unprecedented flexibility in their tactical use, particularly as a substitute for stops.
Let's consider an example in the euro. In recent months a forex trader considering the EUR/USD has seen the Average True Range (ATR) of the day approaching 147 pips and the ATR of the week more than 300 pips. These wide ranges generate a great deal of volatility and wide price swings. As a result, the probability of being stopped out becomes high. Traditional technical approaches such as placing stops above or below the previous day's highs or lows, or above or below Bollinger bands, provide protection but often require the stop distance to be quite large. This is where a binary forex option can help out. Putting on a binary option means that the trader is "paid" when the binary strike price is surpassed. The affect is getting "rebated" when the price moves against you but still being able to remain in the spot position. It is analogous to an auto insurance company paying for small damage repair while the car is drivable.
At Nadex, a binary option contract pays out $100, which represents 10 pips on a standard contract of $100,000. If a trader chooses to go long or short the EUR/USD, he can purchase binary options to hedge that position. Let's assume that the trader goes short one standard contract in the EUR/USD at 1.4970 at 9 a.m. Instead of a stop loss, he buys an 11 a.m. binary option at >1.5020 offered at $20. This means that if the price exceeds 1.5020 at 1 1 a.m., Nadex will pay his account $100. At 11 a.m., the trader also can decide to buy another binary option to offset any further reduction in the value of his spot account. He could put on five contracts and be completely hedged, and if EUR/USD surpasses that strike, it would result in a $400 net gain versus a loss of $500 on the spot price. If the spot position does not reverse against the trader, the total costs would be $100, which is equivalent to only 10 pips. This is a relatively low cost protection premium.
Generally, buying binary options as a substitute for stops can enable the trader to endure a market reversal against him, and stay in the position, anticipating that the reversal of fortune was temporary. The cost of being wrong becomes reduced by the payoffs as the price moves against the position. The major question is whether the cost of the binary options is worth the risk. The risk of course is that the reversal is not serious and the protection was not necessary. As a result, the trader is over-insured. Becoming proficient in using binary options instead of stops also entails timing the entry and exit. The binary option can be left to expire in the money or worthless, or it could be traded for short-term gains.
Binary forex options are worth exploring for legging into a position. This means that instead of putting on a market order going long or short, the trader puts on an intra-hour binary option. If it is hit, this becomes a signal that the market is strong enough to enter a spot position in the same direction. In effect the binary option becomes a momentum signal. Binary options provide yet another benefit to beginning forex traders, allowing them to choose direction and enter positions in a low-cost environment.
New traders can test their skills with binary options before putting serious money at risk. In any case, binary options should be seen as a serious tool for the serious trader.
Abe Cofhas is the author of The Forex Trading Course" and "The Options Trading Course" (Wiley). Reach him at abecofhas@gmail.com.
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