Binary Options Risk Management 101
Every trade has an element of risk. In binary options, there are only two options: win or lose. However, the 50% chance of success or loss in a trade is a constant, so every trader needs to know how to control their risk so that trade losses do not wreck their trading accounts.
Understanding binary options risk management 101 is all about understanding the basis of risk control in binary options.
Risk management in binary options entails:
- Appropriate trade size settings
- Trading psychology
- Understanding the true risks in a trade.
Setting correct trade sizes
Various binary options brokers will give traders their own individual minimum trade sizes. When this is considered along with what is required to be the account funding capital and the maximum acceptable risk for each trade, the trader begins to get an idea of how much exposure the account can take in order to comply with acceptable risk management standards.
Most authorities agree that a risk exposure of not more than 3% at any given time should be applied to an account. If a broker stipulates that the minimum trade size should be $25, then the trader must quickly calculate how much is required to fund the account and how much of that capital should be used in trading at any given time in order not to exceed 3% of the account size. In a nutshell,
- If a broker needs $25 as minimum capital and a trader wants to have two trades of this size active at a time (i.e. $50), then the trader should have at least $2,000 in the trading account.
Remember that the binary options market is an unleveraged market and therefore the trader is responsible for all the capital invested in any trade. If the trader can only afford $1,000, then only one trade of a maximum of $30 investment should be put on at any given time. However, as your trading capital grows so can your maximum trading amount.
What is the connection between trading psychology and risk management? Trading is a psychological event because money, which is the end product of our human endeavors that are channeled towards making a living, is involved. So a losing trade automatically stirs up a desire or a psyche to recover what has been lost as fast as possible. In trading terms, there is just one way that this will manifest, and this is to use larger trade sizes than were previously used in the hope that the increased profit from the next profitable trade would cover for the losses with something extra. Well, a profitable outcome is one scenario and only has a 50% chance of occurring. What then happens if the next trade played with a large trade size ends belly up? The outcome is better imagined.
This is where trading psychology and risk management meet. It has to take a conscious effort by the trader to subdue the “recover-it-now” mentality in favour of a more rational approach to recouping losses. Rational trading psychology actually dictates that it is better to use even lesser risk by reducing the trade size in order to re-establish confidence, before assuming normal risk in a bid to recoup losses.
Certain questions will also come up even when there is no loss to recover and normal risk is used. Questions such as the right time to setup a trade, the expiration time to choose, whether or not to rollover or double an investment, etc, are also questions that border on trading psychology.
Understanding the true risks in a binary options trade
If you look at the numbers, you will see that the chances of winning or losing money in a binary options trade are 50:50. However, there is actually more to lose in a binary options trade than there is to win. Payouts are not usually 100% in a typical Up/Down trade. If you are lucky, you will probably get a payout of 90% of your investment amount, but the average is between 75% and 80%. In contrast, in a losing trade, you will lose all your money. Even the use of the loss return function diminishes the payout you will get in a successful trade, even as it returns some of the invested capital in the event of a losing trade.
Therefore, risk management will entail studying the numbers in more detail and knowing exactly what strategies to use so that the numbers are skewed in your favour. For instance, $100 invested in three losing trades equates to a $300 loss, but it has to take 4 winning trades with the same investment to secure this lost amount as profit. Therefore only trades which have a great chance of success should be applied to your trading account.
We use the example of Alcoa to illustrate this.
You can see that the opening candle was bullish, and indeed, the only trade to have made here was UP for the following reasons:
- There was a falling wedge, which is a bullish reversal pattern.
- The stock in question was boosted by positive news on a new deal with Ford Motors which would lead to demand for its products. So the fundamental news supported the technical play.
- An UP trade with a 1-hour expiration would have clinched the result for the trader.
Such assured trades mean that money is not put at undue risk by betting on trades which are not well analyzed or where the setup is not as clear as this one.
It is hoped that when traders who read this blog and the articles in it consider the issues at play as pertains to risk management as described above, they will learn to manage risk better than their counterparts. Remember that most professional traders never exceed 5% of their trading capital in a single trade.Published in Education