Economic Forces Impacting the Binary Options Market – Part 2

In this second part of the article on the economic forces which impact the binary options market, we take a look at the impact of the economic forces behind the carry trade, the central bank chiefs and the economic calendar itself, as they affect the binary options market place.

Role of Interest Rate Differentials: The Carry Trade

Prior to 2007, one of the most important trade strategies that had been performed in the forex market since the turn of the new millennium was the carry trade strategy. This involved putting on long positions on currencies with higher interest rates, and simultaneously shorting currencies with lower interest rates, thus profiting from the interest rate differential. For a long time, Japan was a classical example of a country operating with near-zero interest rates, and pairing currencies like the Aussie Dollar or the Kiwi Dollar (which at a point boasted of interest rates as high as 8.25%) with the Japanese Yen was a favourite of practitioners of the carry trade.

However, carry trades began to unwind once the global financial collapse occurred in Sept 2008. This forced many central banks to cut rates in a coordinated fashion to stimulate global growth. However, following the slow recovery of the global economy, interest rates have begun a slow move towards the upside, and the world is starting to enter a period of rate tightening. Thus, some carry trade opportunities have begun to return, even though for a much lesser rate of return than was previously the case.

So how does the carry trade work? Basically, a currency will strengthen if the central bank of its economy raises the interest rates, and they currency will weaken if the interest rates are reduced. Central banks use the monetary policy of interest rate adjustments to control inflation. Imposition of higher rates discourages borrowing and reduces the amount of money in circulation, acting as an inflation control mechanism.

Currencies are traded in pairs. When there is an increase in the interest rate on one currency while the rates on the other currency are stagnant or reduced, the net effect is bullishness for the currency with the higher interest rate, because investment money will gravitate towards where higher returns will come from. Here is a list of currencies and their current interest rates:

Interest Rates

•  AUD 2.5%
•  NZD 2.75%
•  EUR 0.25%
•  GBP 0.50%
•  CAD 1.00%
•  USD 0.25%
•  CHF 0.25%
•  PY 0.10%

So why should the carry trade be of interest to binary options traders? It is all about watching the direction of interest rates, and where the real money is flowing into based on the carry trade strategy. One way to see if global markets are following positive carry trade conditions is to look at the Barclays Capital Intelligent Carry Index™ (ICI).

ICI is a fund that executes the carry trade strategy. The direction of the ICI chart will therefore be a direct reflection of the carry trade strategy. Watching this chart would therefore be a positive step in spotting the emergence of better carry trade conditions, and therefore where long term binary options traders should be putting their money. Traders who trade the long term contracts will therefore find this a very useful tool.

Central Banks and Binary Options

Directly following on from the carry trade strategy is the need to track impending central bank decisions and statements regarding their interest rate policies. Most times, what moves the markets as far as interest rates are concerned is not a rate change, but the expectation of rate changes. That is why the words spoken by central bankers when making statements can sway market sentiment remarkably.

Therefore, closely following central bank statements and minutes will place in the hands of the trader, one of the best leading indicators for carry trade or other trading strategies.

So what is the best way to trade a central bank statement in the binary options market? An out-of-the-money strategy is a better approach as these statements are unpredictable can cause market surprises. Consider the May 5, 2009 statement by Jean-Claude Trichet, then ECB Chairman who said he “had no bias towards rates”. This was after the consistent rhetoric about inflation worries which had kept the Euro hawkish for such a long time. The outcome was a significant 1,000 pip drop over a period of several weeks in the value of the Euro as sentiment for the EUR/USD changed from being hawkish to dovish.

The name of the game is surprise. The fastest way for binary option traders to monitor fundamental forces is to scan key indices such as spot gold, crude oil, the USD Index and copper.

For binary traders who use NADEX or Cantor Exchange, there are trading opportunities all week (Monday 3 p.m. EST to Friday 3 p.m. EST) to trade these major sentiment changes. When evaluating market conditions as they relate to currency pairs, there are certain concepts to consider:

1. Interest Rate Expectations: Interest rate expectations are a key driver of currency movements.
2. Relative Growth: How does a country AB measure against another country CD when it comes to growth? If AB shows stronger growth, its currency will rise in value against CD as investment money will gravitate towards AB.
3. Economic Data Releases: The release of high impact economic data will affect currency price movements as these will shift the sentiment of investment money into a currency with strong data and cause flight in another with weaker data.
4. Resistance and Support: These daily and weekly levels are important for traders who trade intraday or use swing trading strategies.
5. Commodity-based currency pairs: The USD/CAD (crude oil) and AUD/USD (gold, copper) are commodity-based pairs which move in reaction to global growth and demand for commodities.

Using an Economic Calendar as Trading Tool

The economic data calendar contains the schedule of economic news releases and serves as a key binary option trading tool. This calendar must be reviewed first before attempting any trading activity. The best place to start is to look at the monthly calendar first, before narrowing it down to daily or weekly analysis. It is going to be very detrimental to a binary options trader to take trades without knowing if an economic data release is lurking around the corner. Such releases can immediately cause trades that are in profit territory to end in bad losses.

The binary option trader can use three approaches to understanding how to trade economic data releases.

1. Economic data releases tend to cause increased volatility level in the markets in the week of release. Greater volatility favours deeper out-of-the-money strike strategies. The rate of volatility change is a key factor. When volatility is at the extremes, it may signal reversal. Refer to our article on volatility tools for more on this.
2. Alternatively, the trader can directly trade an economic data release. This means anticipation of direction of market move is what will deliver profits. Since there is no way of knowing where a news release will point to, a straddle strategy will work in this circumstance.
3. A third approach is to allow the economic release dictate the market direction and then base the trading strategy accordingly.