Forex and binary options trading is a growing sector, especially with the emergence of Internet platforms that allow you to take positions easily and at a reduced cost. But what are the differences between these two products and which one to choose for your investment strategy?
Which underlying assets?
In forex, the underlying asset is, as its name suggests, generally a currency pair such as EUR/GBP or USD/JPY, so the price depends on the relative strength of the two currencies. Forex is a decentralized market in the main financial markets (London, New York, Tokyo), market participants (mainly banks) offer a purchase and sale price that they publish with financial information sources such as Reuters or Bloomberg for their clients, investment funds and large companies. These are the prices that are then reused by your forex broker to offer you a price to buy or sell. So there is no exchange where forex is centralized, which is why we call it the OTC (Over The Counter) market.
By extension, many forex brokers also offer you the opportunity to take a position on commodities (gold, oil, silver, etc.), equities (Total, Apple, Facebook, etc.) or indices (CAC 40, S&P500, Nasdaq, etc.). This is more generally referred to as Contract For Difference, often referred to as CFD. But if forex is so appreciated, it is thanks to the liquidity it offers and its quotation 24 hours a day, five days a week with the possibility of significant movements and therefore profits throughout the day and night.
Binary options do not have this original restriction in terms of available underlyings, you will be able to choose currency pairs, commodities, stocks and indices on almost all platforms such as TopOption. They are also products exchanged by mutual agreement between you and your broker.
What financial principles?
The principle of forex is the easiest to explain, let’s take a concrete case where you want to buy the EUR/USD pair, more precisely take a position of 1000 EUR while the rate is 1.33. You place an order with your broker who will sell for you 1330 USD and give you 1000 EUR. If the rate goes up to 1.34, you can then give the order to close your position and the broker will buy back 133 USD, which will only cost you 1330/1.34 = 992.5 EUR, so you keep 7.5 Euros which are your profit on this transaction.
But what makes forex so attractive is the leverage effect. Your broker can lend you money so that you can take more important positions than your capital would allow and thus multiply your gains (and possibly your losses). Let’s take the example of the above transaction with a leverage of 100:
- Your broker lends you 133,300 USD.
- Your broker sells 133,000 USD by buying 100,000 EUR for you.
- The EUR/USD rate rises to 1.34, you give the order to close the position.
- Your broker buys back 133,000 USD against 99,250 EUR and you keep the rest.
- Your profit is therefore 750 EUR.
Your broker will block part of your funds during the transaction in case you lose money, this is called the initial margin. We took a leverage of 100 so the initial margin was EUR 1000 which became EUR 1750, i.e. a gain of 75% while the “Spot”, i.e. the gross price of the EUR/USD only moved by 0.75%, which is the full power of the leverage effect.
Be careful, the leverage is not without risks, if we had been in the wrong direction, the margin of 1000 EUR would have decreased to 250 EUR and you would have lost 75% of your initial investment. If your margin reaches 0 EUR, your broker will then close the position or ask you to add money to your margin, this is called a “margin call”, the fear of all traders. Finally, since you borrow Dollars from your broker, you will have to pay interest if you want to hold the position overnight, while you will receive interest on the Euros you lend to your broker.
The principle of binary options is very different, a simple binary option has three key factors, its direction (call or put), its maturity (or expiration) and its strike (or opening price). When you buy a binary option, the strike is the spot, i.e. the current price of the underlying asset. So you still have the choice of maturity and direction.
When you buy a binary option, you invest a premium of your choice, unlike a share where you have to pay the share price for example. The payment you will receive at maturity is as follows:
- For a call, if the price of the underlying asset is above the strike, the option expires in the currency, you earn the proposed profit (you recover your premium a profit)
- For a call, if the price of the underlying asset is below the strike, the option expires out of the money, you lose your premium
- For a put, if the price of the underlying asset is below the strike, the option expires out of the money, you earn the proposed profit (you recover your premium a profit)
- For a put, if the price of the underlying asset is above the strike, the option expires in the currency, you lose your premium
If the binary option expires at exactly the same price as the strike, the option is said to expire in the currency and your payment will depend on the broker, some refund your premium, others consider the option a winner or loser.
There are other types of binary options with an on/off barrier (you are paid if the price reaches a threshold, or if it does not reach the limits). Some brokers also offer to resell your binary options before they mature, so you will usually earn a little less of the premium if you were in the currency at the time of sale and recover some money if you were out of the money.
It is in the context of use that forex and binary options vary most, as you may have seen above, the profit system is completely different. Binary options give you the same gain if you end up in the currency of 0.5% or 10% while in forex your gains are proportional to the amplitude of the movement you predicted.
The path the underlying asset follows is very important in forex, if you think a pair will rise by the end of the month but it starts to fall sharply and abruptly, you could have a margin call from your broker. You don’t have this problem with binary options because only the final price will count, no matter how far out of the money your option was as long as it ends in the currency at expiration.
In the range of choices and variations available to you, it is mainly the types of orders that will allow you to develop your Forex strategy (limit, stop, follower stop, etc.) while it is the product itself that will be differentiated with binary options (call, put, 60 seconds, one touch, no touch, etc.)
What are the risks?
With binary options, the risk is limited to the invested premium, you can not lose more than what you initially put. The same applies to earnings, which are limited to the profit offered by your broker. With forex, gains and losses are unlimited, if your margin reaches zero during the day, your position will be cut off. The most dangerous phenomenon is the so-called gap, when a market opens on Monday much lower or much higher than it closed on Friday. Your margin can then become negative and your broker will claim the difference, which is why it is strongly discouraged to hold a position on weekends as it is impossible to leave it. To ensure your positions you can also copy the practices of the best traders on social trading platforms like eToro.
To conclude, these two instruments are used by hedge funds to take offensive or defensive positions depending on the expected scenarios, so it is difficult to say that one is better than the other, why not try both and see which one suits you best?