The difference between binary options and forex
Although traders experienced in trading financial instruments such as foreign exchange can put some of their existing skills to good use in binary options trading, it is important to remember that there are substantial differences between the two.
Trading binary options therefore requires a unique approach.
In this lesson, we will outline some of the key differences between trading forex and trading binary options as well as some of the similarities. This will help you decide which type of instrument you are better suited to trading or, if you choose to trade both, be aware of what needs to be done differently.
Betting versus trading
Although binary options are quite rightly referred to as financial instruments, there are some ways in which they are akin to gambling.
For example, the fact that you know in advance exactly how much you will earn if a trade moves your way makes binary options trading similar to fixed-odds betting on the results of sports matches or other events. Many traders regard binary options as a fast way to win (or lose) money.
For this reason, some countries continue to regulate binary options as a gambling instrument rather than a financial instrument (see Lesson 2 for more information). This is however changing.
In contrast, foreign exchange trading has a real practical purpose for the countless corporates and financial institutions across the world that use the market to facilitate international trade or to hedge currency risk on overseas income and expenditure. Individuals who trade foreign exchange also tend to take more of an investment approach, sometimes trading FX to diversify their trading portfolio or hedge risk on other financial instruments such as company shares or commodities.
Binary options are less complicated
Binary options trading is also generally less complicated than trading foreign exchange.
For example, the size of your payout with a binary option does not change depending on the size of a price move – all that matters is whether a certain point is reached or not. There is therefore no need to actively manage positions once you have entered a trade.
In foreign exchange, however, you earn (or lose) progressively more depending on how far in a certain direction the price of the underlying asset moves. For this reason, it is necessary to manage positions closely to avoid racking up excessive losses, or to use risk management tools like stop losses to automatically exit you from a trade that moves against you.
It is worth noting however that with both binaries and forex, trading can be as sophisticated or as simple as you choose, depending on the level of analysis you undertake and the trading strategies you use.
You cannot lose more than you invest in a binary option
With binary options, you know in advance how much money you will win or lose depending on the outcome. You also cannot lose more than your initial investment. Knowing from the outset what your maximum loss will be makes it easier to manage risk.
In contrast, foreign exchange profits and losses shrink and grow in line with the size of price moves. Losses can easily exceed your initial investment, subjecting you to a margin call. Because of the leverage employed in foreign exchange, such losses can also mount up quickly.
Only some forex trading skills are applicable with binaries
Because of the above, even traders with experience in trading foreign exchange will need to develop new skills and a fresh approach when trading binary options.
They should however find themselves at an advantage compared with complete novices in financial markets.
Skills that foreign exchange traders can put to good use in their binary options trading include technical and fundamental analysis, basic money management, and knowing how to develop a trading plan. Some more intangible benefits that also come with experience are being able to keep a cool head and knowing what time of day you tend to make your best trading decisions.
So far you have learned that:
- you can trade almost any popular financial instrument through binary options
- you can profit from binary options if you correctly predict, whether prices will finish above or below a certain point at the expiry of the options contract
- with a ‘call’ option you speculate on rising prices, and with a put option you expect prices to fall.
- the ’market price’ is the actual price of the underlying instrument, and the ‘strike price’ represents the level that is judged against the market price upon the expiry of the contract, to determine how your bet performed
- ‘in the money’ refers to an expired option that met the predefined criteria and turned a profit; and ‘out of money’ means the option did not fulfil the criteria and you need to take a loss
- there are many different types of binary options such as: high/low options, one touch options, double touch options, no touch options and boundary or range options