The FinancialWhy do Forex Binary Options have Short-term Expirations?
The price dynamics of the forex market has often been characterized by both academics and practitioners as a random walk. This means that the exchange rate of a currency pair has an equal probability of an upward and downward movement, such that the expected change in the exchange rate (at least in the short term) is equal to zero. Consequently, the average trader should not expect to be able to predict the future direction of exchange rates in a consistent manner.
Putting this together with the asymmetric payout of binary options, traders are at a disadvantage when it comes to predicting the short term price movement of exchange rates. It is because of this disadvantage that binary options have short term expirations, which makes it very hard for the trader to predict the direction of exchange rates within a few minutes or hours.
The Bid-Ask Spread
The spread between the bid and ask quotes offered by the broker is an additional cost that the trader must be aware of when dealing with binary options. In general, a broker quotes two prices for an exchange rate: the bid price, which is the price at which the broker will buy an asset at, and the ask price, which is the price at which the broker will sell at. For example, a broker might quote EURUSD at 1.15000 / 1.15004, which means that a trader can buy 1 Euro for 1.15004 USD and can sell 1 Euro for 1.15000 USD.
In the context of binary options, the bid-ask spread is often included in the marking of the option.
As such, a trader who buys a binary call option will have essentially bought into the option at an ask price of EURUSD 1.15004. If we assume that the EURUSD exchange rate does not change and the spread remains the same until the option expires, then the option is closed (or marked to market) at the bid price of 1.15000, which is lower than the initial ask price of 1.15004. This means that the binary call option expires at a loss for the trader.
Consequently, the spread is an additional implied cost that the trader should take into account when trading binary options. During times of low market volatility and during normal trading hours, the spread is expected to remain the same. However, when market volatility is high and during times near the opening and closing of the market, the spread can widen significantly, thus putting the trader at a greater disadvantage.
How can Traders Minimize the Disadvantages Inherent in Binary Options Trading?
As we have mentioned above, the asymmetric payoff of binary options, coupled with the random walk nature of exchange rates in the short term, and the bid-ask spread charged by the broker render binary options a risky investment. However, a trader can take certain measures to minimize the risk associated with binary options trading.
First, traders should conduct proper due diligence and research about the broker they are trading with. In order to minimize the disadvantage associated with an asymmetric payout, traders should select brokers who offer the highest percentage payout.
Second, traders should also check the quoting and marking policy of the broker. Some brokers state that they charge a fixed bid-ask spread, while others state that they have a floating spread. The latter is riskier especially when the market is turbulent, which often implies that the spread will widen.
Third, spreads are typically much wider at the start and end of a trading session. Due to this reason, traders should avoid trading options during these times in order to minimize the likelihood of widening spreads.
Fourth, given the random nature of the foreign exchange market in the short term, traders who possess some predictive skill should opt to trade binary options that have the longest time to expiration. This would give the option enough time to cover the spread as well as move in the direction that they have predicted. The shorter the time to expiration, the less likely it is that the exchange rate will change fast enough to cover the bid-ask spread and reach the target price of the option.
By following the above recommendations, traders would be able to minimize the risk associated with binary options trading and increase the likelihood of having profitable trades.