Risk management is a very important part of any successful trading strategy. Binary options are high risk instruments and it is almost impossible to be able to be a successful trader without being able to limit your risk. Risk management is mainly about money management and how you invest your money but it also about being able to calculate and avoid risk.
Understanding why you need risk management
If you are going to trade with binary options you are going to buy options that matures out of the money. It is impossible to predict the market 100% correct and your goal is not to always be right. Your goal is to be right more often than you are wrong. To be right enough to earn money. To do this you need to make sure that you are able to make numerous bad trades without loosing all your money.
Lets look at an example:
You have found a binary option that you think is a real good buy. You predict that the binary option is going to end up in the money 90% of the time. A near sure thing. In this case it can be tempting to invest a large amount or perhaps even your entire bankroll. To do this is a very bad idea and an example of really bad risk management.
Yes you will usually earn money but one time in ten you are going to loose a lot or even all your money. There is nothing that prevents you from losing money on an option like this 10 times in a row The odds of the next option maturing outside the money remains the same regardless of how many times they have done so in a row already. The past does not affect the odds for something happening in the future. The odds always remain the same.
A risk management strategy makes sure that the randomness associated with each trade is eliminated and makes sure to neutralize the effect of luck over time. It turns binary options to a science.
The most important part of a good risk management strategy is a good money management strategy. The money management strategy should be designed in such a way that it helps you overcome luck by limiting how much you can invest in each individual option. By doing this you will be able to trade with enough binary options to minimize the effect of luck.
There are two main types of money management strategies that are used when trading with binary options. Fixed strategies and risk dependent strategies.
- A fixed strategy limits the amount of money you invest in each option. The amount invested is always the same.
- Risk dependent strategies limits the amount you can invest in each option based on the calculated risk of the binary option. The lower the risk the higher the investment.
It is important that you remember that i saved money is worth just as much as profit. Do not bad choices to chase profits.
Fixed money management strategy
The fixed money management strategy can be a very good option for new traders. It works good and is a lot easier to use than a strategy that takes the perceived risk in consideration. The fixed money management strategy should be designed to provide you with the risk profile you want.
The size of each investment should be based on the total amount of money you have disposable for trading. You should divided the total amount with how many trades you want to be able to do before you lost all your money. The minimum number of trades that we recommend is 50. This is a relatively high risk portfolio. We prefer to use a strategy that allow us to make 100 unsuccessful trades before we deplete our account. This gives us a reasonable cushion against luck and random variations. If you prefer a lower risk profile we recommend that you keep enough money for 200 trades.
If you use our mid-risk strategy based on 100 trades you will need USD 500 in your account to trade options worth USD5 a piece. (500/100=5). If you want to be able to invest more in each option you need a larger total budget.
We are aware that our risk strategy is more conservative than that recommend by many other website. This is because our goal is to build a strategy for long term profitability and not for short time speculation. We look to build fortunes, not to chase quick profits.
Risk dependent strategies
A risk depending strategies will take the likely hood of a certain outcome in consideration when you purchase a option. A strategy of this type is a lot harder to use than a fixed strategy. The reason for this is that you need to be able to calculate the likely hood of the different outcomes for each option. Calculate how large the risk is that it will mature outside the money. There are countless models for doing this and you will need to develop your own based on your investment strategies and based on how you predict market movements.
If you want to use a risk dependent strategy you should divide your bankroll into units. You should invest a different number of units each time you buy a binary option based on the perceived risk. We recommend that you divide your portfolio into 1000 units. If you want a more high risk profile you can reduce this number to 500 and if you want to further reduce your risk you can raise it to 2000.
If you choose to use our recommended strategy then we recommend that you invest 5 units if you buy a binary options that you consider having a 50% chance of maturing in the money. If the option have a 60% chance of success you should invest 6 units, if the chance is 70% you should invest 7 units and so on. This way you put a little more capital to work when the risk is lower. This reduces risk over time.
You should never buy a binary option if you think that chance of it maturing in the money is lower than 50%. We do not invest in options that have less than 60% chance to end in the money. This is due to the fact that you need to correctly predict more than 50% of all your trades to earn money. This is due to the fact that options that ends in the money give a return below 100%.
Do you have enough money?
A key to be able to use a good money management strategy is (as explained above) to have enough money in your account. You need to have enough money to perform at least 50 trades. If you do not have enough money to do this then you will not be able to use money management to reduce risk. If you do not have enough money to make 50 trades we recommend that you save a little more before you start trading.
There are plenty of websites available online that can help you live a more frugal life. Always visit a website that is focused on your local area. If you are Swedish you should visit a Swedish website such as SparaPengar, if you are British you should visit a British website such as MoneySavingExpert and so on. If you live in the US you should have no problem finding a good frugal website yourself. The reason that it is important that you visit a local site is that there are different opportunities to save in different markets.
Be smart & well informed
An important part of any risk management strategy is to have systems in place to always stay informed about the latest market movements and relevant business news. If you are not up to date with the latest developments you will be trading blind and unable to leverage you knowledge into money. Knowledge is what separates successful traders from failing traders.
Having all the latest information allows you to benefit from sudden events instead of being hit by them.
Remember that trading is a numbers game based on math, do not do trades that has a low chance of success, do not trade on emotion and never trade in exotic binary options. Their return rates might look promising but they are big earners for the brokers and very hard to make money from. The brokers have a large edge on these options.
Short options usually give a low return but can despite this be worth trading in to ride a market movement during a limited time.