The relatively recent availability of online binary option trading has made taking binary option positions in a major currency pair just about as easy as trading the spot forex market.
Although this adds another possible risk taking tool to the forex trader’s box of tricks, it remains important to distinguish when trading binary options is preferable to trading spot forex, and vice versa.
Risk and Reward Characteristics of Binary Options Versus Spot Forex Positions
To start with, the primary feature of purchased binary options is their absolutely limited risk that can easily be quantified as soon as the binary is paid for. Basically, the risk in holding a binary option is just the upfront cost or premium that you paid for the binary option.
Furthermore, the reward from buying the binary option is also limited to the pre-determined payout of the binary. This limited risk and reward characteristic of binary options makes assessing the risk to reward ratio of a binary option trade especially easy.
On the other hand, a standard spot forex position has virtually unlimited risk and reward potential, unless offsetting stop loss and take profit orders have been left in the market with a reliable forex broker.
Nevertheless, even if protective orders have been placed, the risk exists of slippage on stop loss orders in fast markets, as well as the risk of a broker’s failure to execute a take profit order despite the order level having been traded at.
Conditions When Holding a Binary Option Might be Preferable to a Spot Forex Position
A significant risk with holding a spot forex position involves trader error. For example, a busy or inattentive forex trader might think they have entered their protective orders, but they actually did not. They might also have forgotten to enter the orders, have had a system failure when entering the orders or lost their trading discipline and moved their orders when they should not have.
Each of these risks can be overcome and effectively eliminated by using a purchased binary option to take a market view on a currency pair, rather than a spot forex position.
Another situation when holding a binary option may be preferable is over the release of a major economic number, like the U.S. Non-Farm Payrolls, or during an important news announcement. Since considerable market volatility can occur immediately after such events as market makers discount the new information into an affected currency pair’s exchange rate, the sharp swings can prematurely trigger a stop loss order, perhaps even incurring unanticipated slippages losses, when the spot position would otherwise have been profitable shortly afterwards. Holding a binary option would allow a trader to weather this storm safely and still come out ahead, if their view turned out to be correct.
Conditions When Holding a Spot Forex Position Might be Preferable to a Binary Option
Although binary options offer considerable security advantages to a forex trader, as illustrated in the section above, this security comes at a price, which is the premium a trader pays to hold the option.
On the other hand, trading spot forex only costs a trader the bid offer spread, which is only a few pips these days. This cost is therefore is pretty much negligible for all but the shortest time frame trading strategies, like scalping perhaps.
As a result, well disciplined forex traders operating in a relatively peaceful and predictable market — and who have taken the time to double check that their protective orders are properly placed with a reputable broker— might feel secure enough to wish to minimize their costs by trading spot forex, rather than purchasing a safer binary option to hold instead.
After all, if the market moves in their spot position’s favor, as they expect, they will not have paid the premium to hold the binary and this will enhance their return by the cost of the binary.
In addition, since the binary only offers a limited payout, the trader using a spot forex position to take a view can follow a trend by trailing their stop loss orders to increasingly more attractive levels behind their position. This strategy would keep their losses limited, while still allowing their profits to accumulate to higher levels than a binary option’s limited payout would have yielded.