how to trade forex options

how to trade forex options

How to trade forex binary options

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 “paid9rdquo; when the binary strike price is surpassed. The affect is getting “rebated9rdquo; 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 11 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.

Options are usually associated with the stock market, but the foreign exchange market also uses these derivatives in trading. It gives traders the opportunity to make money at a risk he has set for himself. To understand this concept better, let us use the example of purchasing a car.

If you hold a contract that requires you can buy a certain car on May 1st at a price of $1,500, you have an option to buy the car. This option ensures that if the value of the car increases at the predetermined time of purchase (in this case on May 1st), then you will profit from it because you can sell the car to another person for more than the amount you originally paid for.

On the other hand, if the value of the car decreases from the original amount, it wouldn’t be beneficial to buy that car. The option gives you the right to buy, in this case, the car but not the responsibility to pay for it if you don’t want to. This significantly lessens the risks to the trader. There are basically two types of options available to retail traders. These include the traditional call/put option and the single payment option trading (SPOT) trading.

The traditional call/put option works very much like the stock option. It gives the buyer the right (but not the obligation) to buy from the option seller at a specified time and price. For example, a trader can purchase the option to buy four lots of EUR/USD at 1.4000 for a certain month (this contract is called a EUR call/USD put). Remember that in the options market, you buy a call and a put at the same time. If the price of the EUR/USD goes below 1.4000, then the buyer loses the premium. But if the EUR/USD increases to 1.6000, then the buyer can use the option and gain the four lots for the agreed upon amount and sell it at a profit.

The Forex option are traded over-the counter. Because of this, Forex traders can easily choose the price and date of their preferred option. They will receive a quote regarding the premium they need to pay in order to get the option. There are two kinds of traditional options available today:

Can be used at any point until the expiration date

Can only be used at the point of expiration

Probably the main advantage of traditional call/put option over its counterpart is the fact that it requires lower premium. In addition, because the American-style option allows it to be traded even before expiration, forex traders gain more flexibility. On the downside, traditional options are requires more work to set and execute compared to SPOT options.

Single Payment Options Trading (SPOT)

SPOT options have almost the same concept as traditional options. The main difference is that the forex trader will first give a scenario (UER/USD will break 1.4000 in 2 weeks), gets a premium, and then receive cash if his scenario occurs. SPOT trading converts the option to cash automatically if your trade is successful. This type of option is very easy to trade because it only requires you to enter a scenario and then wait for the results.

Essentially, if your scenario plays out, you receive cash. But if it is incorrect, you will shoulder the loss of the premium. Another advantage of the SPOT option is it allows a wide variety of choices for the trader. He can choose the exact scenario that he thinks will play out. The main downside of the SPOT premium is that it is higher. In general, it costs significantly more than its counterpart.

Benefits and Downsides of SPOT Options

There are a lot of reasons why SPOT options appeal to a lot of investors and forex traders. Among its many benefits include:

  • Financial risks is limited to the premium (the payment to buy the option)
  • Infinite profit potential
  • The trader sets the price and the date
  • Requires less money up-front compared to the spot Forex position
  • The option can hedge against cash positions and limit risks
  • Options give the opportunity to trade on predictions about future market movements without the risk of losing a lot of capital
  • SPOT options provide a lot of choices including standard options, one-touch SPOT, No-touch SPOT, Digital SPOT, Double one-touch SPOT, and Double no-touch SPOT.

But if options have all these benefits, why isn’t everyone into this type of forex trading? It is important to recognize that it does have its downsides as well.

  • Premium varies depending on the date of the option and strike price. Because of this, the risk/reward ratio fluctuates as well
  • SPOT options are not allowed to be traded. Once you buy it, you can’t sell it
  • It is difficult to predict when and at what price the market will move

What Determines the Option Price?

As was mentioned earlier, the premium price can vary because of several factors. This is why the risk/reward ratio of forex options trading varies. Some of the factors that determine the price are:

This is the current price of the option if it was used. The position of this price against the strike price can be described in three ways such as “in the money” (when the strike price is higher than the current value), “out of money” (the strike price is lower than the current value), and “at the money” (the strike price and the current value are at the same level).

This reflects the uncertainty of market movements over time. In general, the longer the time period of the option, the higher the price you have to pay.

Interest Rate Differential

A change in the interest rates has an impact on the relationship between the strike price and the current market value. This differential is often included in the premium as part of the time value.

High volatility increases the probability that the market price will hit the strike price in a certain timeframe. Volatility is often included as part of the time value. Usually, volatile currencies require higher premiums.

Options offer another opportunity for traders to make a profit with lower risks involved. Forex options, in particular, are prevalent during periods of political uncertainty, important economic developments, and significant volatility. It is up to the trader whether he will take advantage of the opportunity presented by forex options or not.

Let’s go straight to the point. How to define Binary options using your own words? It is a financial instrument that will have its own price (quote) in the certain time; the new price may be higher or lower that the current one.

For example, now we have price of EUR/USD on the level 1.1179 and in 10 minutes the price will be higher or lower than the stated price (pic 1). In case it goes to 1.1180 means the quote increased.

So this changing to the positive or negative side is the double (or binary) opportunity to earn money (up to 90%) or, unfortunately, to lose it. Meaning the trader has two possible scenarios and he has to make the correct prediction. In case 70% of forecasts are made correctly that means you can trade binary options quite profitably.

The main goal of the trader is to make the correct forecast about the further movement direction and open the appropriate trade by clicking the button and choosing the amount of the trade. If your prediction is correct you have the profit 80-90% in your pocket.

The example of trading platform for the binary options.

Main advantages of options trading

Why Binary options may be interesting both or the beginners and professionals?

In contrast to Forex, options trading is much more fast and dynamic, the trading strategies are quite simple there and you don’t have to make a detailed analysis before setting your trade.

How to choose the Options broker

In case you have decided to try options trading, you need to choose the partner of your trading. There are a lot of companies on the market that offer trading services and the beginner in this field may be lost.

The main features that should be counted:

  • The minimum deposit. You can find different options starting from 10 USD or 250 USD. So it’s better to make a correct decision based on your potential.
  • The minimum option size. Here you should understand that you can trade with 1 USD or 25 USD. Your choice should be based on your financial stability.
  • The maximum profit. This criteria is more or less the same in most companies. We recommend to use those that offer 80-90% from one instrument.

To make your choice easier we offer two kind of companies:

Olymp Trade is a new dawn on the market of binary options. This broker have created a company that meets the highest requirements of clients. In Olymp Trade all the stages of trading are as simple as possible, and the entry threshold is lowered to a record sum — 10 dollars.

The broker of binary options 24option established itself as a leading choice in the binary options market. The broker possesses all modern tools and favorable options for a successful trade. 24option is the regulable broker and meets all standards and requirements of CySec. The broker provides training seminars for beginners and qualified technical support.

As well you can check the rating of Binary options companies and be aware of the whole list of the companies.

There is the useful video below that will show you how to trade binary options and stress the aspects for better understanding of the process.

Other useful information for traders:

In fact Forex is a market like any commodity, stock or one that you go each time to buy fresh vegetables. Among all of them there is a similarity, the only difference in what products and what forms of deals are there.

As Forex is currency market, there is currency. The task of the trader will purchase a particular currency as cheaply as possible and sell as expensive as possible. The difference of purchase/sale will be the profit of the trader. Or he could play in lowering the cost. In other words, when a trader knows that the price of the currency in which it will invest in soon to fall, he sells it more expensively and in a short time back buying, but cheaper. Where the difference in cost will be the earnings.

How much money do you need to start Forex trading?

If you want to day trade Forex, we recommend you to open an account with at least $4000, preferably $9000, if you want to get a decent income stream. Using your account of $4000 and at the risk of not more than 1.1% of it on each trade basis ($50 or less), you can charge $80 + for the day. But there’s a whole bunch of options allowing to try your hand investing even a small amount of funds – beginning with $1. Today, there are many Forex brokers, giving the opportunity to exercise and test their strength on a demo account and earn trading real account. A great option for beginners will be the opening of a demo account:

How the trader earns by trading Forex?

Usually, it is hard to understand the principle of earning on the currency fluctuations, for all those who are planning to work with Forex for the first time. An example will help us to describe it for you better. Imagine that you have opened a trading account in the amount of 200 USD. Suppose you are trading on the currency pair EUR/USD. You set upper and lower limit on the chart of the chosen currency pair, then decide whether to sell or buy. Let’s say you made a prediction about the growth of quotations of EUR/USD June 22. You made the decision to buy the currency at a price 1,2056. As a result, bought 5000 EUR spent 6028 USD (5000 x 1,2056). This is possible due to leverage, which is available to conduct transactions for the sum more than 100 times in your trading account. On 3 July the exchange rate was already at 1.33. After a bit of thought you decide to sell the currency EUR 5,000. In the end of the transaction in your account 6650 USD (5000 x 1,33). Your profit will be equal to USD 1650 (6650 – 5000).

Whether it is legal to trade in the Forex?

Yes. Forex trading is legal in the United States and many other countries around the world. In contrast to securities and futures markets, Forex market is not controlled by any Central authority and there are no clearing houses and no of the arbitration Commission. All members trade with each other based on credit agreements.

Forex trading, in fact, is not “investment” in the sense that investment is still investment in bonds or stocks. When a trader trades in Forex he invests his money with risk in the investment strategy. However, risk can be managed using trading strategies.

How To Use FX Options In Forex Trading

Foreign exchange options are a relative unknown in the retail currency world. Although some brokers offer this alternative to spot trading, most don't. Unfortunately, this means investors are missing out. (For a primer on FX options, see Getting Started in Forex Options.)

FX options can be a great way to diversify and even hedge an investor's spot position. Or, they can also be used to speculate on long- or short-term market views rather than trading in the currency spot market.

So, how is this done?

Structuring trades in currency options is actually very similar to doing so in equity options. Putting aside complicated models and math, let's take a look at some basic FX option setups that are used by both novice and experienced traders.

Basic options strategies always start with plain vanilla options. This strategy is the easiest and simplest trade, with the trader buying an outright call or put option in order to express a directional view of the exchange rate.

Placing an outright or naked option position is one of the easiest strategies when it comes to FX options.

Basic Use of a Currency Option

ISE Options Ticker Symbol: AUM

Spot Rate: 1.0186

Long Position (buying an in the money put option): 1 contract February 1.0200 @ 120 pips

Maximum Loss: Premium of 120 pips

Profit potential for this trade is infinite. But in this case, the trade should be set to exit at 0.9950 – the next major support barrier for a maximum profit of 250 pips.

The Debit Spread Trade

The first of these spread trades is the debit spread, also known as the bull call or bear put. Here, the trader is confident of the exchange rate's direction, but wants to play it a bit safer (with a little less risk).

In Figure 2, we see an 81.65 support level emerging in the USD/JPY exchange rate in the beginning of March 2011.

This is a perfect opportunity to place a bull call spread because the price level will likely find some support and climb.Implementing a bull call debit spread would look something like this:

ISE Options Ticker Symbol: YUK

Long Position (buying an in the money call option): 1 contract March 81.50 @ 183 pips

Short Position (selling an out of the money call option): 1 contract March 82.50 @ 135 pips

Net Debit: -183+135 = -48 pips (the maximum loss)

Gross Profit Potential: (82.50 - 81.50) x 10,000 (units per contract) x 0.01 pip = 100 pips

If the USD/JPY currency exchange rate crosses 82.50, the trade stands to profit by 52 pips (100 pips – 48 pips (net debit) = 52 pips)

The Credit Spread Trade

Now, let's refer back to our USD/JPY exchange rate example.

With support at 81.65 and a bullish opinion of the U.S. dollar against the Japanese yen, a trader can implement a bull put strategy in order to capture any upside potential in the currency pair. So, the trade would be broken down like this:

ISE Options Ticker Symbol: YUK

Short Position (selling in the money put option): 1 contract March 82.50 @ 143 pips

Long Position (buying an out of the money put option): 1 contract March 80.50 @ 7 pips

Net Credit: 143 - 7 = 136 pips (the maximum gain)

Potential Loss: (82.50 – 80.50) x 10,000 (units per contract) x 0.01 pip = 200 pips

200 pips – 136 pips (net credit) = 64 pips (maximum loss)

As anyone can see, it's a great strategy to implement when a trader is bullish in a bear market. Not only is the trader gaining from the option premium, but he or she is also avoiding the use of any real cash to implement it.

Both sets of strategies are great for directional plays. (For more on directional plays, see Trade Forex With A Directional Strategy.)

The straddle is a bit simpler to set up compared to credit or debit spread trades. In a straddle, the trader knows that a breakout is imminent, but the direction is unclear. In this case, it's best to buy both a call and a put in order to capture the breakout.

Figure 3 exhibits a great straddle opportunity.

In Figure 3, the USD/JPY exchange rate dropped to just below 82.00 in February and remained in a 50-pip range for the next couple of sessions. Will the spot rate continue lower? Or is this consolidation coming before a move higher? Since we don't know, the best bet would be to apply a straddle similar to the one below:

ISE Options Ticker Symbol: YUK

Long Position (buying at the money put option): 1 contract March 82 @ 45 pips

Long Position (buying at the money call option): 1 contract March 82 @ 50 pips

It is very important that the strike price and expiration are the same. If they are different, this could increase the cost of the trade and decrease the likelihood of a profitable setup.

Net Debit: 95 pips (also the maximum loss)

The potential profit is infinite – similar to the vanilla option. The difference is that one of the options will expire worthless, while the other can be traded for a profit. In our example, the put option expires worthless (-45 pips), while our call option increases in value as the spot rate rises to just under 83.50 – giving us a net 55 pip profit (150 pip profit – 95 pip option premiums = 55 pips).

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