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Binary Options vs. Vanilla Options in Forex Trading

January 6, 2014

According to my last year’s poll about 15% of this blog’s readers use binary options and in their currency trading. 15% also use other types of financial options to trade Forex. Although it is not much compared with the popularity of the spot market, the options can be very useful in portfolio of every trader. However, there are two problems when dealing with online options trading industry:

  • The majority of online Forex traders lack basic understanding of the financial options concept.
  • The binary options have a very poor reputation thanks to many brokers acting like they are online casinos with get-rich-quick attitude.

The first problem will be addressed here by explaining the basics of binary and vanilla options and their main difference. The second problem cannot be addressed by me alone, but I can start by introducing vanilla options and manageable binary options as a viable alternative to gambling opportunities that most popular BO brokers actually offer.

What are options and why traders need them?

Vanilla options are financial contracts that entitle a right to buy or sell a specific asset at a particular price (called strike) on or before an agreed time/date. An example of a call option (bullish) is a contract for a right to buy 1 lot of EUR/USD at 1.4000 (assuming current rate of 1.3670) on December 31, 2014. If you buy such an option, you are betting on significant EUR/USD uptrend during the next year. Your gain on the strike date is calculated as X — 1.4000, where X is the EUR/USD rate on December 31, 2014. For the sake of example, let us consider that it reaches 1.4221. Your end gain is 1.4221 — 1.4000 or 221 pips or $2,210. Depending on the price you paid for this call option, you can calculate your total profit or loss. E.g. if you paid $1,000 for it, your total profit would be $2,210 — $1,000 = $1,210.

You might be asking — what is the point of buying such an option when you could make 551 pips (1.4221 — 1.3670) buying 1 lot of EUR/USD on spot Forex? Because your risk is limited with a call option. If you buy 1 lot of EUR/USD, your risk is virtually limitless. Of course, you would apply a stop-loss, but then it would not be the same trade as using a call option as the latter would not be negated if a price were to reach some deeply unfavorable rate during the holding period. If you are buying a call option instead of a spot, your risk is always fixed.

Let us look at an example of a losing vanilla option trade but now with a put option (bearish). You anticipate a long-term weakness in EUR/USD and decide to buy a put contract on 1 lot of EUR/USD with a strike rate of 1.3500 (the current rate is the same 1.3670) on December 31, 2014. You pay $1,500 for this contract. The year 2014 ends at the same 1.4221 rate as in our previous example. Obviously, your put option does not yield any profit — you will not exercise your right to sell EUR/USD at 1.3500 when the current rate is 1.4221, wouldn’t you? So, your only loss is the price you have paid for the option — $1,500. If you have used a spot trade in this situation, you would have lost 1.4221 — 1.3500 = 721 pips or $7,210.

American and European style options

Vanilla options come in many styles, but the most popular are two of them: American and European. American options can be exited or, simply telling, sold before the expiration time. You might decide to exit a call option to cut your loss if you see that the currency pair is poised to move down. Or you might want to sell a contract when the underlying rate moves in your favor, but you need some cash. In this case, you earn the profit, which is a difference between the price you sold your option for and the price that you have paid for it. In the examples above, you could have sold your call or put contract before December 31, 2014, if you were buying American-style options.

European options cannot be sold before the contract’s expiry date. In the examples above, you would not be able to sell your European options before December 31, 2014. Obviously, European options for the same underlying asset, same entry and strike price and same expiry date should always be valued cheaper or equally to American options. If you are focusing on Forex trading, you will probably never deal with European options as currency options are rarely traded in European style.

Binary options

Binary options are not vanilla options. They are exotic style options as they are neither American nor European. The main difference between the binary and the vanilla options is the fixed outcome of the former: you get a fixed ROI on the contract’s price if option ends in-the-money. This means that binary options have a fixed gain in addition to a fixed loss, which intrinsic to vanilla options. While it can be limiting to your potential profit, it also means that you can potentially earn more than vanilla option would offer in some situations.

Additional difference stems from the current trend in the online binary trading industry — usually brokers award out-of-money option expiration with some minor reward (5–15% of the original option price). It can be a nice consolation if you happen to lose your binary option bet, but you should understand that this out-of-money award is created by cutting the maximum in-the-money award with the same broker.

How to use options to your advantage?

Getting right platform

Despite their disadvantages and apparent difference from the traditional spot Forex trading, both vanilla and binary variants can be used as an auxiliary tool by common retail traders. If you follow my blog, you should have probably read my case study for using a spot FX trade to hedge a binary options trade. There are other ways to combine spot and options, but to do that you have to choose your broker carefully.

First thing to do is to avoid binary trading brokers with inflexible strike prices and times. It is also a bad idea to trade with a binary options providers that forbid exiting a trade before the expiry of the option. Flexible contract size is also a very important property for successful combination of binary and spot trading. If your broker lacks all of the above-mentioned, you can still try trading with it, but I would say that your chances for success are significantly crippled with such companies.

Second, the best binary brokers offer not only standard call/put but also such important option types as “touch”/”no-touch” and “in”/”out” as they are very useful in exercising trade set-ups based on volatility (which is nearly impossible to do in spot market).

Third, going with a vanilla options broker (like Interactive Brokers or Easy-Forex) should be your preferred choice. Unfortunately, with companies offering vanilla options trading, it is still true that the better their conditions and platform the more difficult it is to set up an account with them. You would need at least $10,000 to open an options trading account with Interactive Brokers and also pay for price feed subscription, but you would get an exceptionally powerful options trading platform. With Easy-Forex, starting is much easier (who would have thought!), but their product is less sophisticated and would not satisfy professional participant of options market. You can also try demo-trading vanilla options for free using our white-label platform.

Combining spot and options FX trading

There is a number of ways to enhance your overall trading performance using different kinds of options. Here is a short list of some such methods:

  • An earlier mentioned method for hedging a no-touch option on spot FX market.
  • Binary options can be used to trade on your ideas of the future market volatility. For example, even simple uncovered sale of the normal call and put options can be used to bet on decrease in volatility.
  • Long-term trades are probably safer in options than in spot. When you bet on long-term behavior, you normally want to avoid using stop-loss because it may prevent your trade from maturing. On the other hand, trading spot market without stop-loss can be very risky. This is where buying a call or a put would do the trick for you.
  • You can use data from your options platform to analyze the current market sentiment. Higher values for certain strike prices usually mean higher probability of moving towards those levels.

Poll

I would like to finalize this overview post with a poll to find out the current preferences of this blog’s readers.

Do you prefer Binary or Vanilla Forex options?

View Results

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If you would like emphasize some other advantages or disadvantages of the different types of FX options, please feel free to do so using the form below.

2 Responses to “Binary Options vs. Vanilla Options in Forex Trading”

  1. David

    Nice write-up. For anyone that’s a beginner to binary options trading, I’d suggest only going with brokers that are licensed and regulated. Another tip is to not fall for the promotional bonuses that many platforms offer. You usually have to trade 20X or 50X the bonus amount before you’re able to collect your bonus. Just my two cents.

    Reply

  2. maidul

    This blog is best for newbies who are planning to trade forex trading.I have a doubt about binary option trading and it’s not safe to trade.

    Reply

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