In this lesson we’ll offer an important overview of risk management for binary options, which will help you optimize your trading and reduce risk based on your style and goals. In binary options trading we define risk as the probability of failure of our trades and therefore the possibility of incurring losses. It should be underlined that unlike other derivative instruments, with binary options the risk is limited to that of each individual transaction: if I invest 20 euro, the risk for that trade will be a maximum of 20 euro. The difference immediately arises with trading in CFDs, where the loss affects the capital available on the trading account. It is also useful to clarify that there is no trading method that is 100% safe from losses, so always be wary of “infallible” methods.
It’s also important to start by knowing what the risk potential of a certain trade is, which we will try to understand before opening a new position. This way, we always know what the worst case scenario is and the maximum loss we can incur with any given trade. This loss ceiling is called “risk tolerance”.
Different styles, different rules
The rules for risk management are not the same for everyone, because each of us has their own style of trading (it varies a lot if you are a defensive trader as opposed to an aggressive trader). Likewise, each of us will have their own style of risk management. What we can do now is to advise you to create your own risk management plan, which not everyone does.
Common methods for traditional trading and binary options
In trading with binary options very often very fast operations are chosen that last just a few minutes. Because of this, we can’t use anti-risk methodologies used for traditional trading with CFDs , in which two excellent risk defence systems are very popular: hedging and stop loss.
A very common method to manage one’s own risk and defend one’s self, universally used by all traditional traders, is hedging , a hedging strategy that freezes a certain situation by acquiring symmetrically opposite to the open and losing position.
Another method of reducing risk is stop loss, which is the setting that commands the platform to close a position once a personally-set loss level has been reached.
Risk Management for binary options
In trading with binary options, the situation is very different, since stop loss is not available, and hedging wouldn’t solve much because the profit is a fixed percentage, not proportional to the results.
Many of the risk management techniques with binary options focus on initial capital and on technical and fundamental analysis for the time of entry.
With regard to the first point, the capital, the aim is to maintain quantities of manageable trades with adequate budgets. If you are an aggressive trader and you like to risk a lot, we advise you to open positions up to 5% of your capital at any given time. This means that if you have 10,000 euro in your trading account, the potential losses on all open positions at any given time should never exceed 500 euro. In the same way, if you have a thousand, they should not exceed 50 euro. Traders with more experience, however, use this method but with higher percentages. Most responsible traders, however, do not go beyond 2-3%.
Regarding the second point, analysis is up to you, based on financial news for the stock on which you want to negotiate. News influences stocks differently, depending on the market they belong to and based on the context in which it takes place.
Buy low and sell high
In the management of risk for binary options you’ll always have a great responsibility: that of choosing what to trade. By thinking of the motto “buy low and sell high”, we can learn many things.
Let’s reread this motto with binary options in mind and replace “buy” with “buy options CALL” and “sell” with “buy PUT options”. When we buy CALL options at a very low price (close to the support), it is less likely that they will fall again. So, in this case, we can say that there’s less risk for opening up positions. The same applies to the opposite situation. If a price has reached very high levels compared to its usual (or close to resistance), there’ll be less risk in opening downward positions, i.e. in the purchase of PUT options.
This risk management strategy clashes with the concept of breakdown. There are situations in which certain levels of support or resistance are “broken” and therefore the price actually goes beyond the “low” or “high” that we’ve take as a reference limit. However, break strategies are successful only 30% of the time, so your total risk for losses can be reduced by avoiding these strategies and using the usual market logic to buy low and sell high.
Roll Over and Early Closures
Some brokers offer the option of managing positions in a more flexible way. For example, one risk management tool which helps reduce risk is a roll over, better known as a “roll over for binary options” tool . This allows the trader to postpone the expiration of their trade. That’s right: postpone the expiration of your trade! For trades heading in the wrong direction there is still potential for success, and therefore the possibility of reducing the risk of losses.
One function to consider is an early closure. This operation is practically the opposite of the roll over: it allows you to advance the expiration of a trade. In doing so, when this mode is available, we can close a trade before it expires and cut potential losses. This function can be called different names by each broker, so when you choose a broker, try to see if it is available under the name of Early Exit, early closing, or something similar.
Go to lesson 14 – Books for binary options trading