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Risk management in binary options trading

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binary trading
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Lesson 8

Risk management in binary options trading is the concept of how a trader deals with the losses, at the same time, ensuring he or she is adequately rewarded for the risk taken. Risk management is an essential aspect of trading and covers all types of markets.

To minimize your risk, it is recommended to trade major currency pairs with hourly or daily expiries.

Most professional traders focus on risk management more than anything else. This is because risk is perhaps the weakest link in any trading style. Therefore, it makes a lot of sense to focus on improving this weak point in trading.

On the contrary, most beginners in trading, and to an extent even experienced traders, end up focusing on a winning trading strategy and making profits.

You can see how the priorities are different between professionals and amateurs, and it is also common knowledge as to which among these two classes of traders win the most.

So what is risk management in binary trading, and what does it deal with?

How to lower risk

An obvious question is how to focus on managing risk. How can one go about lowering risk, and is it really that simple? Contrary to what one might believe, risk management is very simple and just requires some common sense. The best way to get started with risk management is by focusing on the following factors.

Expiry time

When it comes to trading binary options, the easiest thing one can do is focus on the contracts’ expiry times. For instance, trading hourly options can be more beneficial in some situations than trading daily expiring binary options.

For example, the U.S. unemployment report is coming out. When the data is stronger than expected, you can expect the U.S. dollar will appreciate. The odds of the U.S. dollar appreciating in the next hour after the new release is much higher than the odds of the U.S. dollar closing the day higher.

Another example is when there is a widely-covered event, such as an interest rate cut or a hike. Such topics are debated and covered for nearly weeks at a stretch. In such cases, on the day of the event, you can be sure the currency pair will close either stronger, for a rate hike, or weaker, for a rate cut, thus making it easier to choose an end of day expiry time instead of a one hour expiry.

As you can see, by applying some common sense, traders can effectively pick the right expiry time to trade, which can help them to indirectly lower the risks of a losing trade.

Payout on contracts

Not all binary options contracts have the same payouts, and this can differ based on the broker you are trading with. However, no matter what, there is one simple rule of thumb to follow.

When you see a broker offering higher payouts on a contract, you can expect that will be a risky trade. It is not surprising that exotic options contracts, such as High Yield, attract 300% or more payouts.

The odds of winning such contracts are low, if not risky. You cannot expect to win by applying the same strategy for a regular CALL/PUT option, as well as for a spread option contract.

As someone once said, choose your battles wisely. This statement is also applicable for binary options traders: they should choose their contracts wisely!

Trading strategy

A trading strategy is also an essential aspect to trading and will determine your overall success. When you combine good risk management with a good trading strategy, you can expect your hard work to pay off as this combination will help you make profits consistently.

A good trading strategy will also help build your trading confidence and, of course, your discipline as well. But how does a trading strategy help with risk management?

Know the odds to be successful

Understanding the risks and rewards of the trade even before you hit CALL or PUT will keep you in a better position when trading. For one, traders know the risks are fixed, which means the onus lies on finding the right trade that can give you consistent profits while compensating for risks as well.

60% winning trades to break even

In forex, it is possible to make money just with a 40% win rate for a trading strategy because, in forex, the risks and rewards are open, unlike binary options. For binary options traders, this means, in order to manage their risks and at the same time focus on building good profit, traders must have a strategy that will give them a 60% win rate.

Depending on the payout in question and the instruments with which you are trading, a proper trading strategy can be employed. One of the biggest mistakes binary traders make is in applying the same trading strategy across all trading instruments.

Learn to accept losses

When a trader fails to acknowledge that losses are a part of trading, he or she cannot expect to make consistent profits in trading, regardless of whether he or she is trading binary options. Trading losses are an essential aspect of trading and are common to traders at all levels. The question is whether your winning trades can compensate for the losses and, more importantly, whether you are able to look beyond these losses.

Liquidity and leverage

Liquidity risk is the risk of your trade (price) not being fulfilled, be at an entry price or an exit price. Leverage risk is where a trader is over-exposed in terms of his or her available capital to trade. While leverage is commonly used in forex trading, as it can magnify winning trades, it can equally decimate your trading capital when you hit a series of losses.

Liquidity risk

While the risks remain, liquidity is not a major issue with binary options as traders are merely looking to speculate on the direction of prices. However, liquidity risk still remains indirectly. Because binary options are derivatives, when there is a liquidity risk in the main underlying markets, it will impact binary options trades as well.

Therefore, choose the instruments wisely and stick to the most popular or major currency pairs and commodity instruments.

Leverage risk

The risk of being leveraged in binary options is null because there is no leverage involved and the brokers offer you fixed risk and fixed rewards. Thus, the risk of leverage can be simply ignored.

Risk management is all about applying common sense, and there is nothing scientific or complex about it.

When a trader focuses on risk management, he or she is indirectly helping him or herself build a robust trading strategy that will eventually bring consistent profits. With binary options trading, it is easy to lose money and it can happen in an instant.

Therefore, focusing on risk management is an essential part of trading that should not be ignored under any circumstances.