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Risk Management in Binary Options

Successful traders are not just those who make profitable trades, but also those who are able to control their risk so that bad trades do not unwind their accounts. There are three basic approaches to risk management in binary options trading, and these are:

  1. Lot size management
  2. Leverage/margin
  3. Emotional control/positive trading psychology

Controlling Risk via Lot Size Management

Using the correct lot size with respect to account size is one single trading factor that many losing traders fail to take cognizance of. Yes, it may be ok to take some risk, but how much risk is too much risk? If you lose a trade which can prove potentially damaging to your account, then you have taken too much risk. Some traders can win 10 trades in a row and feeling very confident, they notch up their lot sizes and get unlucky, seeing their 10 trades undone by just one bad trade.

You must make sure that the lot size you choose for your binary options trade does not radically affect your account to the point that recovery becomes really difficult. It is a generally accepted market rule that the total exposure of all your positions in the market must not be more than 5% of your account size. So when you know the value of 5% of your account in terms of the lot size, you can work out this figure and ensure that you conform to it when setting your binary options positions.

Another rule that can help a trader conform to the right lot size is the rule of threes. The rule of threes refers to the number of lots the trader can assume in both trade entries and trade exits. The trader can therefore either go all in with all three lots, or go in sequentially one lot at a time. He may also decide to exit all three lots at once, or exit one lot after the other by first closing a portion of the position and then risking the rest. In online binary options trading, the Double Up function mimics the rule of three, though not to a very large degree.

The issue here is: which of the rules of three will be the most appropriate in any market situation? This will require a careful study of the market in terms of technical and fundamental analysis. Let us use a chart pattern to illustrate the rule of three entries.

Let us assume that the price action has broken through a side of a chart pattern, and we expect breakout to continue from there. Do you go all in at the open of the next candle, or do you go in sequentially one lot at a time?

Scenario 1

If we use a short term chart (say a one hour chart) in which there is not much of a pip distance between the close of the breakout candle and the broken trend line, you may decide to go all in knowing that the price action would still work in your favour even if a minor pullback occurs. The short pip distance would ensure that the trade recovers in time to put your position in the money.

Scenario 2

Breakout CandleOn the other hand, if the same setup were to occur on a long term chart (e.g. daily chart), we would be wary of going all in at the open of the candle following the breakout candle. This is because the pip distance between this point and the trend line is much, and if a pullback were to occur, it would indeed take quite some time for the price to get moving in our preferred direction, which would not be good for a binary option trade with an intraday or end of day expiry.

In this daily chart, we see that after the breakout of the upper trend line in the channel, the move took three days to take off (day 1 – 3 candles).

However, the day 1 candle was a pullback candle from the breakout high/close, and was 153 pips from the broken trend line. A trader who goes all in after the breakout candle on an end of day expiry will suffer a loss in this trade. But a trader who went in first with one lot would lose on the 1st lot, and gain on the second lot (entry at trend line on day 2 candle) and also on the 3rd lot (entry at trend line on day 3 candle), leading to a net gain of 1 lot.

Controlling Risk via Leverage/Margin

The binary options market is basically an unleveraged market, so losses cannot be magnified beyond what is invested into the trade. In a platform like NADEX however where trade sizes are measured in lots, usually a portion of the account will be used as margin to hold down a particular position. This is where the trader must therefore calculate the risk to reward ratio for the trade so as to avoid using large margins to hold trades in which only little profits will be gained.

Controlling Risk via Trader Psychology

A large component of the trading strategy used to capture gains in the financial markets is emotionally driven. The mind is a great battle zone when it comes to trading binary options. There are many things that have to be contended with as far as emotions are concerned. There will be questions, doubts and convictions in the trader’s mind.

  • Is this the right time to enter the trade?
  • What expiry time should I use?
  • Should I cash out early or hold on for the full profit?
  • Should I double up my investment?
  • Is it ok for me to roll over my investment or simply take my losses now and move on?

There are many emotions at play and these emotions usually lead traders to ask these questions, or take decisions about their trades in response to these questions. Quite commonly, we see traders who become very hesitant in taking glaring profit opportunities after coming off a real bad losing streak, and we also see traders who start getting overconfident and careless coming off winning streaks. Sometimes, the emotions may be one of confusion, which is a resultant factor of taking in too much information, or learning and trying to make use of too many strategies. The interplay of emotions is a battle that is always at work, and getting a firm control of the negative emotions is not always that easy.

Applying risk management through psychology is all about conditioning one’s self to use positive emotions and ditching negative emotions when trading. This is a short guide as to how this can be achieved:

Use a ranking system to rate your emotional input into the trades you are making. This ranking would be done in terms of how confident you are in the trades working out according to plan.

  1. Very confident
  2. Confident
  3. Tentatively confident

Of course setting a trade when you have no belief that it will succeed (which corresponds to 2 and below) is not a good way to control risk, because that would not an emotionally balanced trade; something we want to avoid.

There are some books out there which dwell on the topic of trader psychology. Trading with the right psychology is a skill which has to be nurtured and developed. Reading some of these books will help the trader do just that:

  1. Trading in the Zone – Master the Market with Confidence, Discipline and a Winning Attitude by Mark Douglas.
  2. The Psychology of Trading – Tools and Techniques for Minding the Markets by Brett N. Steenbarger, PhD.
  3. Trading for a Living – Psychology Trading Tactics Money Management by Alexander Elder.
  4. How to Become a Successful Trader – The Trading Personality Profile by Ned Gandevani.

There are several other books on trading psychology, but these four are a good place to start from.

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