4. Managing Financial Risk
OK, you have an account (or accounts) open and you are familiar with how the platform works. All ready to go? Not just yet. Before deciding what you will trade, when and in what direction, you must decide how much you will trade. Being clear about this is the key to managing risk when trading binary options. Most of the advice in this regard, and in the remaining chapters of this eBook, is equally applicable whether you are trading exchange traded or OTC products. However, to avoid repetition it generally refers to OTC situations.
Advice on risk management is available from a number of brokerages who provide eBooks or other training materials. In general, these appear to fairly consistently advocate 5% as the maximum risk per trade for a passive trader and identify 10% per trade for an aggressive trader. This means that you would make the stake on each trade equal to 5% (or 10%) of your trading fund. They also note that the total amount of money at risk at any time should not exceed 15% of the fund for a passive trader i.e. there should be no more than 3 trades open, or 25% for an aggressive trader.
While you might find these eBooks useful, you should remember that they are provided by brokerage firms and it is reasonable to assume that they will prioritise their interests. These which might not be the same as yours.
For a start, you should dismiss the notion of whether you might be a passive trader or an aggressive trader either at some points in time or in general. You can never be sure of the outcome of any trade and having a consistently successful system that provides you with a sufficiently high level of wins, with good risk control, is the way to success. You should be confident but emotionally neutral regarding the markets. Being aggressive or passive are emotional states and are damaging.
So dismiss that idea. So, what percentage of the fund is it appropriate to risk on any trade? I consider that 5% is too high and I would never countenance 10% risk. To see why, assume that you trade with 5% risk but you do not have a proven system so that you are correct only 50% of the time. After all, you have nothing yet to think we can do better than random. Assume you place 5 trades in a day. The chances or probability of being wrong and losing our stake on all 5 is 1 in 32 i.e. 1 over 25 . If this was to happen your account would lose 25% of its value in just one day (or set of 5 consecutive trades). Are you comfortable with that? I know I’m not. It would be enough to put me off trading for a considerable period.
Notice also that if you lost 25% then you need to make 33% on your remaining fund just to recover. If we assume an average payout ratio of 80%, this means we would need to be right for the next 8 trades in order to recover quickly. The chances of that are 1 in 256 i.e. 1 over 28 . Notice not only how quickly losses can mount and how much more difficult it is to recover?
The golden rule is that you should not risk more than 2% of your equity on any trade and ideally you will limit it to less. Never be tempted to increase this just because you feel good about the markets and feel like being ‘aggressive’.
There’s a further issue also, Assume you have 3 trades open in different markets and some unforeseen event causes market disruption. It could be a political announcement or a natural disaster. You would lose all 3 trades. If you have 15% of you fund tied up in those 3 trades it is a very bad day for you as a trader indeed.
I recommend two rules that must be followed:
There is plenty of alternative advice out there but it tends to lead to risks that I would not wish to take. The danger is that you could incur losses in a very short period of time from which it would be very hard to recover. So be cautious, particularly when starting to test a system.
Remember there is no shortage of opportunities to trade and the markets will be open again tomorrow – so you don’t need to risk too much on any trade or at any point in time. Just make sure you are in a position to trade tomorrow in order to be able to avail of the opportunities.