Why are asset correlations an issue when it comes to binary options? Binary options are a relatively new type of trade investment which has a few unique features. One of these unique features is on the structure of the brokerage service system that is served to clients in this market. Unlike the direct market access brokers found in other markets that allow traders to trade using pricing from the liquidity providers as opposed to pricing from the brokers, the binary options market is exclusively made up of brokers who aggregate orders from traders and execute them conditionally. The keyword here is “conditionally”, which means that certain conditions must be met before a binary options trade is either executed or even allowed by the broker to take place.
Here is what the binary options brokers will never tell you. Every trade has two possible options: A or B, win or lose, high or low, call or put. So for every trade, you will have traders on both sides of the equation. Let us say there are 100 traders looking to trade the EURUSD on a binary options platform. If we have 40 traders betting $100 each that the EURUSD will rise and 60 traders betting $100 each that the currency pair will fall, and the price actually rises when the trade expires, then the broker will pay the winning traders anything between $65 or $80 maximum from the $100 bet by each of the 60 losing traders. This allows the brokers to pocket between $35 and $20 per trader for each trade that goes this way.
But what if there is something like a news release which makes 95 out of 100 traders bet $100 that the EURUSD will rise? This is where the broker is going to have a problem, because if all the traders are right in their analysis, then the broker will be forced to cough up the money required to pay the traders, since the number of traders on the losing side will not produce enough money to take care of the winning payouts. So what the brokers do is to “freeze” the platform, ensuring that no trades can be made on the asset. This can be very frustrating for the trader.
This is where trading asset correlations in the binary options market becomes an important tool for a trader who wishes to profit from the market whenever there is a situation that leads to an asset being “unavailable for trading”.
Some assets traded in the financial markets are correlated, that is, their price movements are in tandem with the movements of other assets either in the same direction or in opposite directions. Thus, it is possible to make a prediction of the movement of the price of one asset based on the price movement of a correlated asset with a high degree of certainty.
So it has been established that during news trades, it is very likely that the broker may make certain assets unavailable for trading if the order flows in a particular direction overwhelm the ability of the broker to fill them. In these instances, traders who have a knowledge of correlated assets can take advantage of them and trade assets that mirror the direction of a news trade, even when the assets commonly traded for such news are unavailable for trading. It therefore would make a lot of sense to understand what assets can be traded in a correlated manner.
Examples of Correlated Assets
Here is an explanation of the various correlations in binary options and how they can be traded.
- AUDUSD and Copper
Both assets are inherently tied to Chinese manufacturing data, especially the Flash PMI data. About 40% of the world’s industrial production is carried out in China. Mnay brands we know today including Apple, all have factories in China. To drive this industrial activity, China has to import raw materials to from Australia and other commodity producing countries such as Zambia (one of the largest copper producing countries in the world) and South Africa. Now supposing you want to trade the Chinese Flash PMI data on your binary options platform, the natural currency of choice would be the AUDUSD. But what if the AUDUSD is made unavailable for trading at this time? A natural choice would be to trade the copper asset.
Copper and AUDUSD both move in a positive correlation in response to Chinese data. So if the news data from China is not good, it is expected that the AUDUSD and copper will go down in response, and vice versa.
- NFP vs USDJPY, Dow and Nikkei225
When the Non-Farm Payrolls report is released, the effects are seen across a wide range of assets. The assets most affected by the NFP are the USDJPY, the Dow and the Nikkei 225 stock indices. This is almost like a chain reaction. The NFP data have an effect on the USDJPY and the Dow, which in turn have an effect on the outcome of trading on the Nikkei225 index the following Monday. The cascade effect is pronounced because the Japanese markets would have closed for the week by the time the NFP is released on the 1st Friday of the month, so the natural response of the Japanese stock index would be to the NFP data. Many of Japan’s goods are sold in the US and so the US Jobs data provides an accurate measure of the health of the companies that produce these goods in Japan, many of which are listed on the Nikkei225.
So rather than trade the USDJPY in response to the NFP data, the trader may trade the DJ30 stock index asset or the Nikkei225 index asset.
- Commodity Currencies and US Fed Interest Rate
There is a relationship between the value of commodity currencies and the US Fed interest rate. A rate increase by the US Federal Reserve is highly anticipated to occur before the end of 2015. An increase in interest rates means that the value of interest earned on investments in the affected country will be higher than before. An increase in the interest rate by the Feds will make the US a natural destination for investment money, which will in turn exit the emerging markets and cause the value of the emerging market currencies, their markets and their commodity products to drop.
So if the US Fed Reserve Board comes through with the rate increase, we would expect the following emerging markets to feel the heat: Brazil, South Africa, India, Turkey, etc. So rather than trade the USD directly, a logical play may be to trade gold, the USDZAR or USDBRL instead.