What the heck is Binary Option Trading?
Remember that with normal call or put options, the payoff is calculated by adding or subtracting the closing price at the expiration date from the "strike" price of the contract--minus the cost of the option position (aka premium paid). A binary option is a contract where the trader chooses whether or not the market will be at, above, or below a certain price level. It's an "all-or-nothing" type of financial play in that if the price of the underlying asset is in-the-money, the full reward is paid. But if the market price is out-of-the-money, then it you lose the premium paid to enter the option.
Just like normal options, binary options can contain underlying assets like forex contracts, equities, and other financial instruments.
What's the difference between Forex Trading and Binary Option Trading?
Both include a component of analysis and speculation as you need to form an idea of where the market may be at a certain point in time. Now, the major difference comes in the form of calculating the profit and loss, as well as the potential duration of the trade.
In spot forex trading, you calculate your profit (or loss) by multiplying the numbers of pips you are up or down by the value per pip, which based on your position size. The profit or loss is constantly changing as the market moves until the trade is closed.
On the other hand, when you trade binary options, you will always know in advance how much you stand to gain or lose as soon as you put the trade on. No matter where the market goes, those values are constant.
Let me clear this up with an example. Let's say you were long biased EUR/USD and the market is at 1.3400. We'll first take on this view with a spot forex trade:
You decided to go long 1 lot EUR/USD at 1.3400 and that price jumps up to 1.3500 in a day. That's a nice profit so you decide to close out your position. This means you've made 100 pips, giving you a profit of 100 x $10 = $1,000.
But another scenario could be that the market immediately turned against you and you decide to close the position at 1.3350 instead, you would have lost 50 pips x $10, or $500. Or, if you close the position at 1.3400, you would have broken even.
Now let's take an example of a binary option.
Let's say you bought a binary call option on EUR/USD with a strike price of 1.3500, expiring in three months. You bought this option for $250, with the agreement being that if EUR/USD is at or above 1.3500 at the end of the contract, you would be paid $1000 (the payout is determined by the broker). This means that at the end of the three months, if EUR/USD is trading at or above 1.3500, you'll make $1,000 - $250 = $750. On the other hand, if it EUR/USD isn't trading at or above 1.3500, you'll lose the $250 you put up.
As you can see, the major differences between the two types of trading are the maximum potential profit / loss and the duration of the trade. In spot forex, the profit and loss can be huge with strong trends and there is not really a time component, but with binary options, risk and reward is absolutely capped and taken only at the contract expiration.
Which is best for you? Well, that all depends on your trading personality and preferences.
Will the rising popularity of binary options trading affect you?
Not directly. But now that the CFTC is tightening its regulatory belt on the forex brokers in the US, this may lead investors to choose binary options brokerages instead of retail spot forex brokers. This could lessen the competition in the industry and ultimately limit the choices of forex traders.
Or we may eventually see brokers offer binary options trading as a part of their current services. Unfortunately, brokerages that can do this are most likely the larger ones who have the funding and power to develop such services. This may lead to an industry structure where only the big brokers can afford to provide a diverse portfolio of services to everyday traders like you and me.
Now that you've learned a thing or two about binary options trading, do you think that it's something that you would want to trade? More importantly, do you believe that binary options trading has the potential to attract a lot of market players, enough to be a threat to forex trading?
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