Last Updated on February 7, 2021 by Patrick Mahinge
What is the difference between forex trading (also called Foreign Exchange) and binary options? You can find this question on countless internet forums at the moment. This question makes no sense. If you don’t understand why, you should not try to make money with binary options.
These two investments are extremely different, they do not share the same purposes, they do not share the same economic reasons and they concern two different types of investors.
We already compared binary options with common options; we will now try to present the key differences between forex trading and binary options on forex.
Differences between binary options on forex and regular forex
In order to help you understand the key differences between these two instruments, we will remind you the definition of these two investments:
- Forex is a market: it is the market of currency exchanges. A forex trader limits his exposure to the currency exchange market. A forex trader will never speculate on a company stock, a commodity or any other asset class. He will for instance invest in the Euro-Dollar. He will buy a certain amount of dollars with a certain amount of euro in the off chance that, in the future, he will be able to re-exchange this same amount of dollar for a bigger amount of euros. This is what happens when the EURUSD exchange rate is decreasing. A forex trader will say that the Dollar appreciates against the Euro. Moreover, the forex market is used by many different market participants. A company that sells its goods abroad in dollars but pays its employees in British pounds will need to use the forex market to convert these earned dollars for a in British pounds.
- A Binary option is an instrument: a financial instrument that enables retail traders to speculate on different markets (forex, equity stocks, indices, commodities…). It also enables them to leverage their investment in order to generate high profits in a short amount of time. Binary options are derivative products with a final payoff that is conditional to the level of the underlying asset at maturity of the option.
- FOREX – A forex trader is bullish on the US dollar against the Euro and spot rate is 1.3230. He will invest 1000 EUR and buy 1323 dollars. One month later, the EURUSD exchange is 1.3120, the trader will convert its 1323 USD and get back (1323 / 1.3120) 1008.38 EUR. In one month, the forex trader generates a profit of 8.38 euros. You need to invest large amounts of cash to make money with forex trading.
- BINARY OPTIONS – A binary option trader is also bullish on the US Dollar against the Euro and the current exchange rate is still 1.3230. He will invest 100 EUR on a LOW binary option on EURUSD with maturity 15 minutes and a RETURN of 75%. If after 15 minutes, the EURUSD exchange rate is below 1.3230, the trader generates a profit of 75 Euro while he only invested 100 euros. You don’t need to invest a large amount of cash to generate a large profit with binary options. Compared to forex, the binary option trader cannot lose more than its invested amount.
Differences and main advantages of binary options versus forex
- Larger portfolio of available underlying assets (stocks, indices, commodities and of course forex).
- Losses are limited to your invested amount and you already know your achievable return when you open the transaction.
- No collateral requirement by the broker. When you want to invest 100 GBP, you only need to have 100 GBP on your account while brokers are requesting bigger capital requirements for pure forex trading.
- Multiple instruments and strategies available (High / Low, One Touch, Zone…).
- Greater freedom and transparency: you can craft your own binary options with the « option builder » while pure forex investment are standardized.
- No commission on binary options while proportional commission on forex that can represent a significant share of your investment.
Ultimately, the success of binary options is mainly due to the multiple advantages of this financial instrument compared to forex and other traditional financial tools. Binary options are simple instrument, you just need to choose a direction for a specific underlying and be right about it to make money.
Is Binary Options Easier Than Forex Trading?
If you are new to financial markets, it is a legitimate question to ask yourself. Is binary options trading easy compared to forex? Is it more risky? From a theoretical point of view: we would say yes!
Binary options are a lot easier to understand than forex trading instruments (CFD, Swaps, Forward Rate Agreements, Dual Currency Notes…). All these financial instrument valuations are impacted by many factors such as volatility, deposit rates, leverage level, bond yields…
The way binary options operate and generate profit or loss is a lot more straightforward. You know the achievable return of your investment at the inception of the transaction. The only factor that will impact the payoff of your investment is the price of the underlying at maturity.
Never forget the risk associated with binary options
Let’s say you buy a HIGH binary option on an asset with maturity 15 minutes and a return of 80%. Only two outcomes are possible. Either the price of the asset after 15 minutes is above the initial price and you earn the return, or the price of the asset after 15 minutes is below the initial price and you lose your invested amount. You may nevertheless recover the “return on loss” proposed by most brokers.
It is relatively easy to understand binary options
For those of you who would like to have a first experience in trading, binary options are one of the most adequate financial tools. You don’t need years of experience in financial markets, trading, technical and fundamental analysis to trade binary options. It is really easy to understand how they operate and there are few factors to select and adjust.
Of course, you should never forget the risks implied by such financial instruments. If you invest on the wrong scenario, you are likely to lose all your invested capital in a short period of time.
However, most forex instruments can result in losses far greater than the invested amount if the market moves in the wrong direction. This is because most forex instruments are leveraged instruments. You only invest a small portion of the required capital (1% to 5%) but you have to add more capital if the underlying asset goes in the opposite direction.
Most people start to understand these differences. This is why forex volumes are steadily trending lower over the last years while binary option volumes are exploding. This also explains why more and more forex brokers are adding binary options to their instrument portfolios.
However, pure-players such as OptionTime, AnyOption, TopOption or 24option already have a strong track record in the binary option trading business and it will be hard for newcomers to compete.