Money Management for Binary Options Trading

The following binary options lesson teaches the basics of risk and money management.

Risks Management Strategies for Binary Options

The amount of money that an investor should risk on a trade is a function of a number of factors which include the amount of money allocated to trading binary options, and risk management strategies that can optimize the returns of that portfolio.

Risk management is generally considered a defensive strategy as the techniques that are used are focused on minimizing loses and avoiding the risk of ruin.  A basic concept of risk is that it is highly correlated to reward.  As an investor increases the amount of capital they are willing to risk, their potential reward increases.  The key to a successful investment strategy is to determine the optimal risk to assume to achieve a specific return profile.

money management binary options

Pre-defined Risk / Reward

One of the benefits of binary options trading is that the returns are fixed, and the most an investor can lose is the amount risked on an individual trade.  With above or below options, an investor will usually see a return of 75-85% of the amount risked on a trade.

For example, a trader who makes a $10 trade will usually see a return on a winning trade of 18%, assuming an 80% return.  There are also many high yielding binary options such as one-touch options which can have a payout profile as high as 350%.  Even in the cases of high yielding returns, the most an investor can lose is the amount risked on the trade. To learn more about the win-rate required for different payouts, read this lesson here.

In other forms of trading, a risk to reward ratio of 1:2 is the standard target. For example, if a trader sets his stop-loss 10 pips below the current price then he’ll aim for a 20 pip take profit (1:2). In binary options, the stop-loss/take-profit is irrelevant because of the fixed risk-reward of the trader, which would be 100:85 for an 85% payout.

Risk

Risk can be defined as the possibility of loss. For example if an investor purchases a call binary option, there is a possibility of a price decline, which puts the investor at risk. The loss itself is not the risk; instead the possibility of loss is the risk. There are a number of techniques to control the risk, but with binary options the risk is pre-determine and so are the gains.

Trade Size

Touch OptionTo achieve the most attractive trading size, investors need to determine most efficient amount of capital to use when making an investment.  There are a number of strategies that can be used to determine the trade size of an investment, which include a fixed bet or a fixed-fraction bet.

1. In a fixed betting system, the amount of capital remains the same no matter how large the portfolio grows.  In this instance, an investor would place trades of $50 dollars regardless of whether the trade becomes proportionately too large or too small.  A $50 dollar bet on an account size of $1,000 dollars seems reasonable, but it would be considered large on a $100 dollar portfolio and small on a $100,000 portfolio.  Generally a 5% trade size of the total portfolio is considered reasonable, for trades that an investor has strong confidence in.  That would mean on a $1,000 portfolio that is geared toward trading binary options an investor would risk $50 dollars per trade.

To remedy this problem of the equity within the portfolio drifting out of proportion to the fixed bet, an investor can define a bet size as a fixed fraction of the equity within a portfolio. A 5% fixed-fraction bet would, on our original $1,000, also lead to a $50 bet. If the equity rises or falls, the fixed-fraction bet stays in proportion to the equity.  So if the portfolio became $10,000 the fix-fraction bet would increase to $500 dollars.

2. Another technique a binary option trader can use is to alter the bet size based on the payout and volatility.  For example, short term 60 second options would require a smaller bet size as the payout is smaller and the volatility is greater than a daily above or below option.  Additionally, traders should avoid situations where they are taking bets on days when there is high volatility based on an important economic data release, unless the binary option trade is predicated solely on the results of the release.

Kelly Criterion

Generating the optimal bet size is a process similar to probability.  This process of finding this optimal number has been best described by the Kelly criterion, developed by John Kelly.  Kelly created a simple formula that describes the optimal strategy for non-correlated trades.

Kelly Criterion formula: f= (bp – q) / b

•                f is the fraction of the current portfolio

•                b is the net odds received on the trade

•                p is the probability of winning;

•                q is the probability of losing, which is 1 – p

Risk vs. Reward

There are a number of ways investors can modify the Kelly Criterion to find a process that is more in tune with their trading style.  One of the most important concepts in determining trade size is risk relative to reward.  If the reward of a trade is compensated beyond the relative risk it is considered a robust bet.

Summary

Trade size is an important concept that should be analyzed prior to creating a portfolio in an effort to achieve the most efficient risk adjusted returns.  Trade sizes that are too large will potential create the risk of losing an investor’s entire portfolio at some point, while bet sizes that are too small will never meet and investors expected returns.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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