Forex and binary options are primarily the same products from the broader financial markets spectrum, however, their similarity ends there. For traders who contemplate whether to trade forex or binary options, this article aims to present a clear picture of the difference between forex and binary options.
Binary options, or ‘Options’ as they are often referred to, fall under the category of the derivatives markets. The derivatives market is made up of financial products whose value is derived from the actual market. Other examples besides options include ETF’s, Eminis which although similar are not exactly the actual products that you trade, but are products designed to reflect the actual security.
Similarly, when comparing forex to binary options, the binary options (for forex) are derived from the spot forex markets and similarly, binary options for equities (stocks), commodities and so on are derived from the actual stock market and commodities futures markets respectively.
Although binary options are derivative in nature, it doesn’t change the way they are traded. Therefore, binary options and forex are speculative in nature where traders make money from the rising and falling markets.
Main Differences between Binary Options and Forex Trading
When it comes to trading binary options or forex, there are some main differences between the two as outlined below.
Trading Approach: With forex, speculation is based on buying (or selling) at a certain price and exiting (closing the trade) for a profit. For example, with forex, it is as simple as buying Euro Dollar (EURUSD) at 1.30, and selling (closing the trade) at 1.31 to make 100 pips in profit. With forex, a trade is considered successful when it reaches its target price (or as long as price is above your buy price or below the level of your sell price).
With binary options, there is no ‘target level’ to achieve, but rather the direction within the constraints of time. For example, a CALL option is considered to be ‘in-the-money’ (successful) when price is above your entry price within the time period of the options expiry time. In binary options, the only level to consider is the Strike Price. The price level at which you purchase your CALL or PUT option. If you purchased EURUSD CALL option at a strike price of 1.30 with a 1 hour expiry, then if EURUSD is trading above your strike price (1.30) you can make a profit (even if price was at 1.3001).
Leverage: Leverage is a common feature when it comes to the forex markets. Due to the minute price swings (known as pips), a trader, unless having a trading equity of 1,000,000 the profits are minuscule. Leverage allows traders to magnify their trading accordingly and thus makes it easy for a trader with $100 equity to trade in the likes of mini lots (0.1 or 10,000 units). On the same note, high leverage can lead to magnified losses as well.
Leverage is virtually non-existent with binary options. This is due to the way they are traded (refer to the ‘Trading Approach’ section above to know why).
Risks: There is a lot of marketing hype that makes one to believe that binary options are fixed risk. Spot Fx traders would know that by setting a stop loss level, they too can limit their risks. However, the main difference in regards to risk with binary options or forex is that, in binary options, the amount you can lose is always equal to the amount you invest (some binary options brokers allow you to insure some part of your investment, but it is not more than 25%, while using this option will also reduce your payouts). In forex, the amount you risk depends on how close or far your stop loss level is set to and therefore, the risk can vary.
Forex and Binary Options – The Business Model
Another aspect worth noting is the business model of forex and binary options brokerages. At a very broad and simple level, forex business model is where your wins and losses become another trader’s losses or wins. For example, an ECN forex broker would simply charge commission on your trade. When you win a trade, the amount of profit you make basically comes off other trader’s losing positions (to keep it very very simple).
With binary options, the business model defines that the number of net losers with a binary options broker needs to be higher than the net winners. For example if a binary options broker has 100 traders trading with them, then if all the 100 traders win in-the-money getting a 60% payout, the broker ends up paying them $60 x 100 = $600. Now, if we assume 50 traders win and 50 traders lose, each investing $100, then:
Winners: $100 x 50 traders = $5000 from which 60% payout = -$3500
Losers: $100 x 50 traders = $5000 from which 0 payouts – +$5000
The binary options broker has a net profit of $1500. You can do the math from here on. The above example is very basic and simple. In reality due to the different types of options (short term, long term, and so on) it can get a bit complex. But the overall model remains the same.
However, this should not be alarming because the binary options brokers don’t really need to rig the prices. The basic facet of ‘greed’ does a job good enough to ensure that the brokers always have more losing traders and than winning traders and at a basic level a 50-50 ratio of winners and losers is enough for the broker to make a decent profit from your trades.
Forex or Binary Options?
This brings us to the question of which is better… Forex or binary options?
Well, honestly there is no right answer to this and it is purely subjective and based on a trader’s specific risk tolerance, trading approach and so on. It would be worth mentioning however that most traders (including Forex, Equities, Futures) do look to options as a way to hedge potential risks. While trading binary options alone can be profitable, the advantage of options is perhaps best reflected in their ability to help traders in hedging.