Risk management in binary option trading
When trading, like in any activity which involves risk, you have to have a clear and coherent Money Management plan. Without it you will be trying to build a house without laying the foundations first. Many traders miss out on this important aspect of trading, as there are more things to consider than just counting your money. Then just as important as working out a plan is sticking to it, Discipline is the golden rule here.
Construction of a coherent plan begins by asking yourself the following 3 questions;
- How much do I want to risk overall?
- How much do I want to risk per day?
- How much can I risk per trade?
Risk management in binary option trading
Answering the first question can be reasonably easy, for example, I have 5000$ and I want to put my trading skills to the test so that is the sum I can afford to risk. Yet out of the 5000$ you begin with, you may limit your maximum loss to say 2500$, which is reasonable. If your trading only results in losses, and you find yourself losing 50% of your capital, it is probably best to stop. Take a step back and try and figure out what is going wrong. It would seem evident by this point that there is something wrong with your trading plan and it needs reconsidering.
The second question is a bit trickier and takes a bit more thought. How often are you thinking of trading? Given the above example, how quickly are you willing to risk going through 2500$ before you have to stop? My feeling is that you shouldn’t want to risk burning your capital out in less than 2 to 4 weeks, which means 10 to 20 trading days. So you should be thinking along the lines of 1/10th to 1/20th of your capital per day. This means that you would be risking between 250$ and 125$ a day.
Are you an ‘active’ trader?
This assumes you are going to trade actively, or trade at least once a day. What if you only intend to trade occasionally? Perhaps on the back of an idea you have had, or a recent news line. Say you might trade every 2 or 3 days. In this case it could be very tempting to think that you can sum the cash you didn’t risk on the days where you didn’t place a trade. So “I didn’t trade for 2 days, I can risk 750$ or 375$ today on one trade“. This in reality just increases the risk you are taking, and you could find yourself down 2250$ with just three bad trades. Yes, it could still take you two weeks to accumulate this loss, but it has only taken you 3 wrong trades, and that can happen very easily. So again in this case it’s best to remain with 1/10th or 1/20th per trading day or something closer to 1/20th if it’s all going on one trade.
This leads us to answer the last question, how much to risk is acceptable per trade? This depends on how many times you want to trade a day and if you are willing to spend a lot of time in front of your screen. It may well be that you only have enough time to put on 1 trade a day, in which case I would recommend that your single trade (and daily risk) are both, at the most, 1/20th of your risk capital, in the above case 125$.
Let’s say you’ve decided to risk 200$ a day trading binary options and you plan to trade every day. You could put that all on one trade and see if you were successful. This would ultimately be the riskiest route. It does depend on how much time you can dedicate to trading but I would split whatever daily number you have decided into between 2 to 4 trades. You don’t necessarily have to make them all, but it’s better to give yourself a few chances a day, not just one. If you have the time, splitting the daily risk size in various trades may be more rewarding.
Applying Money management to Binary Options
The thing I like most about trading Binary Options is that risk is well under control. You know how much your maximum risk per trade is when you place it, and it is simply the cost of the option. However human emotions can come into play, especially on a bad day. As we have seen above if you lose your daily risk amount then basically you should turn off your screen and wait for tomorrow.
This is probably the hardest task to follow. As a trader you are going to feel you can get it right, just one more try is all you need. But we should look at it this way, let’s say you have 210$ daily risk limit, which you break into 3 trades of 70$ each. If you happened to get all three wrong you are unlikely to get the fourth one right either, simply due to fatigue or trading based on emotion.
By this point you may well be upset or not in emotional equilibrium, this can lead to bad judgement and is more likely to make you pick another trade that loses. From a money point of view you are down 210$ and placing another trade will give you the chance to make back at best 90% or 63$, which won’t turn you a profit for the day, but losing that trade will now bring you down another 70$ to a total loss of 280$ for the day. That can only feel worse, and more dangerously can start a very risky spiral where you have no more limits on how much you can lose a day or in total. Limits are a good way to encourage discipline within trading.
You could also add more rules or limits. Taking the above example (210$ daily limit split into 3 trades), you could add the rule; 2 straight losses and I’m out for the day. For example, say that you start the day with 3 straight wins, no reason to stop on a winning streak. But now let’s say you lose the next two. Now you still have profit for the day, and can walk away. This rule, of 2 losses and out, will protect your gains for the day and limit losing not only what you gained but also your daily risk limit. If you continue trading you may make two more winning trades but you may make two more losing trades, in which case from being up 210$ for the day you now find yourself down 70$ for the day. The “2 straight losing trades = out” rule can help in protecting your winnings. Remember in trading one of the most important concepts is capital preservation, and being able to trade again tomorrow.
Rules such as these may suit some investors and not others – but the three fundamental questions remain. One thing that every single broker can agree on, is that money management is of paramount importance when it comes to trading success.
