I am currently very piqued by how would I use order flow knowledge to trade Binary Options which is the craze now at the present moment. How would I use the info about Stops, OBs etc to trade Binary? Appreciate your thoughts. Thanks.
Here is my review of the binary options, their advantages and disadvantages, things to look out for, etc.
Binary Option = Digital Option
In its most simple form, a binary option where you choose a put or call, is the “digital option” that hedge funds use. They are talked about in the Mastery Course lesson: http://orderflowforex.com/digital-option/
Therefore, binary option = digital option. Now, I would say, most of the exotic option activity doesn’t occur in the digital options, for various reasons. In order for a hedge fund to buy a digital option, depending on how they structure it, it can cost a lot of money. I have seen plenty of digital options costing 50% – 95% of the payout amount. So if a hedge fund wanted to buy a digital option with a $10 mln payout, depending on the expiration date, strike price, volatility in the market, etc, they may have to pay anywhere from $5 million to $9 million of the option payout up front. There are some hedge funds that do that because they gain the flexibility that even if the digital option expires just 1 pip in the money, they get the full payout amount.
Good Flexibility Advantage
That is one type of flexibility that the binary options offer. Same thing on these binary option websites. If you purchase such a binary option, then you just need the option to expire just 1 pip in the money to make the full payout.
Disadvantage – Lack of Big Winners
However, there is a big disadvantage associated with this. While you gain flexibility in making the payout (since you only need it to expire 1 pip in your favor), you lose in other ways. If the market explodes with volatility in your favor, you don’t get any more money because the payout is limited. Both the risk is limited, and the reward is limited. You don’t take on gap risk because you bought the option, so the maximum you can lose is the option premium you paid. Your reward is limited to the payout you agreed to when you bought the option.
So one of the disadvantages with these binary options is that you can’t have huge winning trades. The 5R, 10R, 20R, 30R trades, etc, you can’t have them because your maximum profit is limited. If the market explodes in your favor with a MDMM or GM move, you don’t get the benefit of it. And that lack of big winners can be a big problem, because most traders rely on some decent sized winners to cover the losses and make a profit. This forces you into a high win rate system when trading binary options. You need high win rates to make the numbers work. And high win rate strategies, in my experience, require the ability to get in and out of trades very quickly. In some ways you can get high win rates because you only need the market to expire just 1 pip in your favor to make the payout. But that cuts both ways. What if it expires 1 pip out of the money?
On the other hand, someone who is trading the vanilla puts and calls options, let’s say in the stock market, they get the benefit of limiting the risk to the option premium, but they gain the potential to have big gains if there is big volatility in their favor. The reward is not predetermined with the vanilla puts and calls. While the reward is predetermined with the binary options.
Not being able to take advantage of big volatility in your favor, is a big problem with these binary options. You need to catch some big trades some of the time during the year. Especially if a trader has a small account ($1,000 – $30,000) or so and aspires to take it to a large account. You have to find some big trades in your favor.
As a general rule, from every Market Wizard and trading book I have read, and from my own experiences, in order to achieve large percentage gains, then you need volatility in your favor.
One Touch Options
It seems Optionrally.com also has options for a One Touch Option, which increases the payout percentage to around 3x – 5x what you risked. Which is decent. And you only need the barrier price to get hit once and you make your payout. Again, your reward is capped in this case, but it is more in line with what some of the hedge fund players in the exotic option market do. They try to structure options that cost around 20% of payout, and if they make the payout, they win 4x what they risked about paying the option premium. Which is a decent trading system if you have a decent win rate.
However, I am uncertain as to the pricing algorithm that these binary option brokers use to price the trades they present to their customers. I am unsure as to how their prices compare to what the real exotic option market in the forex market is pricing the options. I am not that good in such math and statistics, as my edge lies more in proper interpretation of the information flow and scenario analysis. And I don’t know if there is enough potential (due to lack of resale value, and relying on broker to give you the money talked about below) with these binary options to make spending hundreds of hours on them worth it.
Lack of Resale Value
The other disadvantage is that these binary options seem to lack liquidity and resale value. You can’t really sell them or liquidate them or close them out before they expire. Once you buy them, that’s it. Either you make the payout, or you lose your option premium.
Also, what if you change your view in the middle of the day and think the market is going to reverse? You can’t liquidate the option and use that cash to bet on the opposite direction. You are stuck with the trade to see what happens.
Let’s say you do some analysis and think USD/JPY is going to go up and buy a $100 call binary option that expires in 24 hours, with a payout of $170 if the option pays off. What if you do analysis in 12 hours that makes you believes the market is going to drop precipitously? You are stuck with the $100 you spent on the call binary option. I don’t believe you can liquidate it on many of these binary option broker websites. Please correct me if I am wrong here.
Fictitious and Unregulated Market
With these binary option brokers, you are usually at the whim of them. You have to accept their prices for the options. There is no one else providing liquidity. Only your broker is providing liquidity to you.
If you can’t get out of a trade, then it is more like a betting website.
You have more counterparty risk, because what if these bucket shop binary option brokers go under? They may not pay out on their trades they have made with you. And your funds with them may be in danger.
Also, if your profits come directly from your brokers pocket, what incentive do they have to have you keep trading and growing an account with them? The more you win, the more they have to pay out to you.
At least the regular spot forex brokers make some money either off commissions they charge, or off the big/ask spread and they can try to hedge those trades at a profit. With these binary option trades, your broker cannot really hedge them effectively.
Unless they charge a commission on the binary option trades that I am unaware of?
Regulated Option Exchange Is Probably Better
Which is why, I would say if you are going to do option trading, then, if you have the money to do it, then to do stock option trading or futures option trading. At least those occur on regulated exchanges, where you don’t have to worry as much about counterparty risk. And you get the benefit of having liquidity to get out of trades and can have big winning trades if you play the vanilla options and have big volatility in your favor.
It would be nice for retail traders if they had some options available for spot forex. Currently, there are only options on the currency futures contracts on the CME, which are good, but they only have limited currency pairs. If you wanted an option on the EUR/AUD lets say, then you couldn’t do that in the futures market. You would have to do in the spot forex market, with those option markets only available to the hedge funds and institutional participants.
In my opinion, optionrally.com is grossly misrepresenting the risk and reward in the binary option market.
Take the example here of “Higher potential profits” section: http://www.optionrally.com/optionrally-advantages
For example, imagine that you believe that the price of oil is about to increase. Consequently, you decide to purchase oil at $90.00 by making an investment of $1000. Now, if you were to action this investment by buying shares directly in oil then should this commodity rise in value by 10% then you would profit by $100.
However, if you were to invest your $1,000 in a ‘call’ binary option whose underlying asses is oil, then you would make a pre-determined 78% profit with OptionRally. In other words, you would receive a payout equaling $780 if the price of your binary option finishes just one tick higher than your opening or strike price.
They make it sound so easy and alluring that you can make a 78% profit. But that is very misleading. Let’s think about it together in terms of key trading principles and position sizing.
If you “invest” $1,000 in a call binary option for oil, and you win the trade and get paid 78%, you are making $1,780. However, you paid $1,000 for the option. So 1,780 – 1,000, and you only made $780. You risked $1,000 to make $780!
How horrible is that! That is not even a 1:1 reward to risk ratio. That is just plain bad trading as it requires. How long can you last risking $1,000 on every trade, to make only $780 in profit on a successful trade?
For example, if you buy 10 of those binary options, costing $1,000 each, that is $10,000 in cost.
If you win 8 of them, you make +$4,240 in profit.
If you win 6 of them, you make +$680 profit.
If you win 5 of them, you LOSE -$1,100
So you need around a 60% win rate, just to break even and make a small profit. You only make big money if you have a 80% win rate +
Trading the Better Way
In my opinion, traders would be much better off if they chop up the risk that they take on the binary option into smaller trades and go for big volatility moves.
For example, if someone was going to spend $1,000 per binary option and buy 10 of them for $10,000 cost, his maximum profit with 78% payout is: +7,800.
It would be far better in my opinion, to split that $10,000 into smaller chunks and risk it in the normal market with directional trades, or with the regulated option exchanges, where the potential profit is open ended.
If you chop up $10,000 into ten different $1,000 directional bets, who knows how much you can make? If you lose 9 of the trades for a -$9,000 loss, but win just 1 big trade of +10R, you still made a profit of $1,000 with just 10% win rate.
Or if you caught a few big winners, such as one 10R trade, and another 18R trade lets say, and another 4R trade, that is a total of +32R, minus 10R for the cost of the trades (since 1R = $1,000), and you get a profit of +22R, which is +$22,000 in profit with just a 30% win rate.
Or if you chop up the $10,000 into $500 risk chunks, or $250 risk chunks, you can get a lot of trades in and longevity of the trading account and can chain together a lot of high reward risk ratio trades if you can find them.
Advantages of these Binary Option Brokers
If I had to find advantages of these binary option brokers, then there are two of them.
First, they allow you to trade these binary options with smaller account sizes. Someone can open up an account with just a few hundred or few thousand dollars and place these trades. So it is accessible to the smaller account size, if someone is worried that they don’t have $10k or more to try to fund a standard trading account.
The second advantage is that they offer interesting customization options. You can structure these expiries to 15 min intervals, etc to try to take advantage of the news spikes + Go for intraday move, etc. These customization options make it very interesting as you can structure trades with only 1 min expiry, 15 min expiry, 1hour expiry, etc.
For example, if you do some news analysis and believe that after the FM spike, the market probably is going to be higher 15 min from now or 1 hour or 2 hours, you can use that information flow advantage to buy a call binary option, and it just needs to expire 1 pip in your favor within 15 minutes, 1 hour, or 2 hours.
Other advantages include which some are mentioned above: You only need the market to settle 1 pip in your favor. You can’t get stopped out by a spike against you, etc. You can trade a wide range of markets around the world such as stock indices, commodities, etc with smaller account sizes than normal.
But again, the disadvantages is that you struggle to have big winning trades, which is a VERY BIG disadvantage in my view, and something that most traders struggle with.
Optionrally.com may not be the best choice. There are so many to choose from. Depending on what country you are from, from a very quick overview, it seems nadex.com might be a better choice for people who want to engage in binary options. They are more regulated and can be more fair. They may even offer the ability to close out the binary option prior to expiration. Nadex may also offer much better pricing options and cheaper binary options. I have not taken an in depth look at it, but just from a quick glance.
If you believe I have missed something, or interpreted something the wrong way, please let me know as I want to get my facts right!