In this article, we will examine how traders can limit their exposure to risk when trading forex and binary options by using a stop loss order when they enter a forex position in conjunction with a binary option investment.
Many forex traders look to the release of important economic news and information as a basis for their trades. They often wait until a scheduled economic report is set to be released to lock in a forex investment in the hopes that their prediction of the report’s outcome will be correct and will influence the currency pair they have chosen in the desired manner.
The problem is that the financial markets are very fickle and are constantly being influenced by a plethora of factors that makes them likely to move in unexpected directions at a moment’s notice.
Forex Stop Loss Order + Forex Binary Option
One way to limit a trader’s exposure to risk when entering a forex trade is to simultaneously invest in a forex binary option on the same currency pair and to define a stop loss order for the forex trade that is directly based on the option’s potential payout.
How do you decide the stop loss rate?
Most binary options pay out between 70-85% when they finish in-the-money (and 5-10% when they finish out-of-the-money). That being said, your stop loss order needs to be defined by how much your binary option might pay out if it finishes successfully.
Let’s operate on the assumption that for every pip you lose on your forex position, you’re losing $10. In the case of an investment of $250 in a forex binary option with an 80% payout, you could expect a financial return of $200 with an in-the-money finish.
In that case, you would want to define your stop loss on your forex position at a rate of 20 pips lower, if you’re going long, or 20 pips higher, if you’re going short – so that your maximum forex loss would be $200. This would enable you to break even if your option finishes successfully but your forex position closes at a loss.
In order to elucidate how this strategy would look in reality, let’s take the example of yesterday’s (August 1, 2011) ISM manufacturing index release.
Click on chart to expand
Using the 5-minute EUR/USD chart above, let’s say you locked in your long EUR/USD trade and your $250 put on an EUR/USD binary option at a rate of $1.4333 at 14:00 GMT. You would have defined the stop loss order at 20 pips below $1.4333 – so $1.4313 – in order to allow a situation where your forex trade closes at a loss but your binary option goes on to finish in-the-money.
In the example above, your forex position would have closed a few minutes after 14:00 once the EUR/USD hit $1.4313 but your EUR/USD option would have finished in the money one hour later since the EUR/USD was trading at 1.4198 at 15:00 which is lower than its rate at 14:00.
Results of Strategy
Long positon on EUR/USD:
- 1.4313 (EUR/USD at ~14:05) – 1.4333 (EUR/USD at 14:00) = -.0020 (20 pips)
- -.0020 x $100,000 (one lot) = -$200 loss
EUR/USD binary option:
- $250 PUT on EUR/USD with 15:00 expiry: $250 * 80% in-the-money payout: $200 profit
Total: -$200 forex loss + $200 binary option profit = $0
What would have happened if you had gone short – instead of long – on EUR/USD and invested in a CALL – instead of a PUT – on the forex option?
Let’s say you locked in your short EUR/USD trade and your $250 call on an EUR/USD binary option at a rate of $1.4333 at 14:00 GMT. You would have defined the stop loss order at 20 pips above $1.4333 – so $1.4353 – in order to allow a situation where your forex trade closes at a loss but your binary option goes on to finish in-the-money.
Using the situation above, let’s examine what the results would have been one hour later at 15:00:
Results of Strategy
Short positon on EUR/USD:
- 1.4198 (EUR/USD at 15:00) – 1.4333 (EUR/USD at 14:00) = -.0135 (135 pips)
- -.0135 x $100,000 (one lot) = $1,350 profit
EUR/USD binary option:
- $250 CALL on EUR/USD with 15:00 expiry: $250 * 10% out-of-the-money payout: -$225 loss
Total: $1,350 forex profit + -$125 binary option loss = $1225 Net profit
As you can see, it clearly would have been better to go short on EUR/USD in this example. However, if you had gone long, you could have limited your losses to $0 by investing in a fx option and defining a forex stop loss order based upon the option’s in-the-money payout.
Keep in mind that, there is a chance that your forex position could close at a loss early and your binary option could finish out-of-the-money as well. This could happen if EUR/USD drops 20 pips one way and triggers your stop loss and then rebounds to finish 20+ pips in the opposite direction by the option’s expiry time. So, this strategy, like all trading strategies is not 100% foolproof but it can, when employed correctly, help reduce risk exposure and ensure higher trading returns.