Difference between Binary Options & Forex Trading
Binary Options called as such because the outcome is always black or white, “all or nothing” even if your contract ends up ” in” or “out” of the money by a cent.
Both forex and binary option trading are very popular among traders these days, and many new traders are curious what the differences between the two are. While both forex and binary option trading can be done online, at any hour of the day, the ways in which they handle risk and exposure are quite different.
So what are binary options and how do they differ from regular Forex trading? Well, on the most basic level, options trading is exactly how it sounds. There are two options, either the currency goes up or down. You open a position by guessing which direction it will go.
Forex trading is essentially the practice of trading in one currency by purchasing it with units of another currency. As a result it deals with what are referred to as currency pairs – a trading currency and a currency traded in. Every major currency in the world is traded in.
Perhaps one of the most appealing aspects to many investors in Forex Trading, however, is the ability to leverage purchases a great deal. Because the swing of currency pairs is generally quite small, brokers in the forex market feel comfortable offering the highest degree of leverage in any market – as high as 200:1. This means that an investor with only $1000 on hand could make a $200,000 purchase. While this increases the amount of profit that can be made, it also greatly increases the amount of exposure to the investor. While it is rare for currencies to swing widely enough to overtake the leveraged position, when it does happen it can spell catastrophe.
In order to understand binary options it is useful to get a general idea of what a traditional option is and how it works.
The “regular” options are contracts where the buyer pays for the right to buy or sell an underlying asset at a given price, whereas a binary option is a contract where the buyer pays for the right to receive a fixed return in case the price of the underlying asset ends up above or below the strike price.
Options trading is generally a lot simpler than Forex trading. The platforms are all Web-based and all you have to do is click an up or down arrow. It really could not get simpler. In Options Trading, you know exactly how much you are going to profit or lose without the volatility risk of regular trading. This also simplifies the binary options trading arena.
Binary options make use of fixed contract lengths. Unlike straight forex trading, which generally uses stops and limit orders to try to manage when a position is exited, the binary option trader knows from the outset when their contract is going to expire, and when they will have exited their position fully.
Unlike straight forex trading, binary option trading of forex does not use leveraging. Instead, the payouts involved in an in-the-money trade are naturally high (generally around 160% to 180%). In this way binary option traders can still use a relatively small amount of initial capital to make large gains, but because they can never lose more than they’ve invested, their exposure is much less.
The flip side to Options Trading is that there are a very limited number of reliable binary trading brokers from which you can choose as opposed to Forex trading brokers, which are available by the hundreds, if not thousands.
To illustrate binary options, let’s assume that you want to buy a CALL option on ACME Inc, if you buy a regular option contract, and the price of the stock ends up above the strike price by the expiration date (that will be mentioned when purchasing the option), then you will be able to exercise the right to purchase the stock at that price regardless of its current trading price.
In this case your profit could come in two ways:
1. You could sell the “in the money option” before expiration and make a profit from the difference between the purchase price of the contract and the selling price (which will obviously be higher because it is in the money).
2. You could simply wait until the contract has expired and buy the stock at the price of the strike and then sell it at the trading price thus making a profit from the difference between the strike price and the trading price.
In both cases your profit will depend on the magnitude of the movement in the price of the stock.
However, it is important to note that if your contract expires out of the money it becomes worthless and you would lose 100% of your investment in this case.
Now, if you where to buy a binary CALL option on Google your profits would realize in a completely different fashion:
1. Binary option contracts do not expire monthly, but hourly or daily, which means that your profits (or losses) realize within these time frames.
2. A binary option contract will pay you the fixed return (usually between 65%-81%) regardless of the magnitude of the movement in the price of the underlying asset, as long as it expires in the money by at least $0.001.
With binary options it will not matter if ACME Inc’s shares went up $1 or $40 above the strike price of your contract (assuming you purchased a CALL option), you will get paid the same return either way, whereas in a traditional option contract your return will depend entirely on the magnitude of the movement in the price of the stock.