The Perfect Product for Beginner Forex Traders: Binary Options
Author: James Ramelli / AlphaShark Trading
Binary options are something most traders are at least somewhat familiar with but many traders associate binary options with risky trade setups and high levels of volatility. While the all or nothing settlement nature of binary options can lead to higher volatility in returns, traders who know how to use them properly can take advantage of superior risk management capabilities that are difficult to replicate when compared to trading the outright underlying market.
To illustrate this point we will go over some comparison examples of binary option trade setups in the forex markets. A trader can take their current trading plan and work these types of trades into it. When using the binary options your trade setups will offer a trader clear advantage choices and the limited risk nature of the trades is something that beginner traders can greatly benefit from. Let’s start with a simple day trade setup.
In the chart below we can see a signal for a long entry in the AUD/USD firing on the 15 min bar. This upside break of the Ichimoku Cloud is confirmed by higher time frames so it is a long signal that a trader can take with a relatively high level of confidence. This signal fired at 12:35pm ET on Wednesday 2/24.
Focusing on the oval shape in the chart above, the bar closing above the Ichimoku Cloud signals a trader to either get long the spot pair at the close of the bar or use binary options. As you can see the market does not rally at first and the signal appears to be failing. The main difference between approaching this with binary options vs. the underlying pair is how we handle this initial sell off after entry. Let’s compare the two trades.
Binary Trade: Buying the AUD/USD > 0.7700 3pm Binary option for $25
Risk: $25 per 1 lot
Reward: $75 per 1 lot
In this trade we are getting an even 3-1 reward to risk ratio and have a guaranteed maximum level of risk. No matter what happens in to the underlying market this trade can never lose a trade more than $25 per 1 lot.
Spot Trade: Buying the AUD/USD for 0.7689
Risk: Move to 0
The risk in the trade above is essentially unlimited. The trader is exposed to every move lower when holding this position. As the market sold off after the initial signal the trader would have seen their losses growing substantially. If the trade had a stop loss in place they may have been taken out of the trade.
As we can see in the chart however, the AUD/USD market eventually rallied and made a new high for the day. If the spot trader was stopped out of their position they would not have participated in this rally at all. They would have had to re-enter the trade and add more risk to the position.
The binary trade allowed the trader to stay in their position as the market moved lower. Of course the binary option lost value as the market moved lower but since it cannot settle for less than zero a trader knew that they could hold the position though the move and hope for the AUD/USD market to rally back. As the market moved higher it actually closed above the binary strike price at expiry and a trader would have received a full payout. In this setup a trader would have had a 300 percent return on their initial investment and of course had the trade not worked, their trade exposure would have been limited to the $25 per contract if holding till expiration. To replicate that in the underlying would be very difficult.
So we can see from these setups that the binary options trader has some clear advantages. They are getting a well-defined reward to risk setup and have a guaranteed level of maximum risk. This would be impossible to replicate in the underlying. Even when trading a small lot of the spot forex pair would have cost a trader far more in margin and risk. While margin varies from broker to broker a trader can say with certainty that they would have needed more than $25 in capital to take on the trade. In an ROI comparison the binary trade is still superior to the spot trade. To set up a similar reward to risk scenario a trader would need to use a single profit target that is three times bigger than the traders stop. Since the binary trade is only looking for a move to 0.7700 to achieve full value the spot trade would require a very small stop to replicate the same reward to risk. This is far too small of a stop for a trader to have any hope of staying in the trade. This would be the only way to achieve anything close to the huge profit potential the binary options trade offers. The guaranteed risk in the binary trade is an added benefit of the setup.
This guaranteed level of risk also allows a trader to stay in the trade even though it initially went against the trader. All of these dynamics make the binary option a fantastic way for a beginner trader to approach setups in the forex market. The limited risk nature of these products can help a trader master their strategy without risking a large amount of capital. If you are struggling with your trading, you may want to consider trying binary options.
Nadex Risk Disclaimer
- Trading on Nadex involves financial risk and may not be appropriate for all investors. The information presented here is for information and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Any trading decisions that you make are solely your responsibility. Past performance is not indicative of future results. Nadex instruments include forex, stock indexes, commodity futures, and economic events.
- Nadex binary options and spreads can be volatile and investors risk losing their investment on any given transaction. However, the limited-risk nature of Nadex contracts ensures investors cannot lose more than the cost to enter the transaction. Nadex is subject to U.S. regulatory oversight by the CFTC.