Money management for binary options trading
Risk management is what defines you as a trader, rather than a gambler, and sensible money management is its most important ingredient. Without money management, your career as a binary options trader could prove very short-lived.
In this lesson we will outline the key principles of money management and why it is so important for binary options traders in particular.
We will help you work out how much of your available trading capital or deposit you should use in any one position. We will also introduce you to other strategies that will help you control losses and maximise your long-term returns, depending on whether you favour low-, medium- or high-risk strategies.
The importance of money management
While gambling involves exposing yourself to high risks in exchange for the low probability of a large payout, trading involves taking calculated risks that will result in smaller but more regular profits while controlling the size of any losses when they inevitably occur.
Money management is the least ‘sexy’ element of binary options trading, with some novice traders preferring to focus on studying new trading strategies and technical indicators than dedicating time to this discipline. Unfortunately, many learn the hard way how vital money management really is. The ‘all or nothing’ nature of binary options trading makes money management especially important.
No matter how good you are at predicting price moves, no trader gets its right every time. The trick with binary options trading is to ensure that when losses do occur, they are small enough that you still have enough money in your trading account to live another day - and hopefully win back your money.
Only risking a small portion of your deposit on any one trade will also help keep you clear-headed and calm – essential for good decision-making. Nothing clouds a trader’s judgement like greed or desperation, so try and never put yourself in a position where the outcome of a trade is make or break.
The Kelly criterion
One money-management strategy that is popular with binary options traders is the Kelly criterion, or Kelly system - a mathematical formula designed to minimise risk and maximise profits. Traders use the Kelly criterion to work out - based on the probability of a trade making or losing them money - what proportion of their trading capital they should place on individual trades.
In the case of binary options that have just two possible outcomes, the Kelly criterion typically dictates that traders use just 1/19th of their available capital on any one trade. For purposes of ease, most traders round this down to 1/20th, or 5%. For contracts offering a 70% payout, a winning trade would offer you a 3.5% return on a 5% risk.
If, for example, you have £1,000 in your trading account, the optimum amount of money you should invest in any single binary options contract is £50.
While this may seem disappointingly small to ambitious new traders, it means you would have to lose 20 times in a row to wipe out your entire trading account.
Other money management strategies
There are a number of other techniques that binary options traders employ to limit their losses to a manageable level, depending on whether they have a high, medium or low appetite for risk.
Cap the number of winning or losing trades
This technique involves placing a limit on the number of winning or losing trades you make in any one day. If, for example, you have a low appetite for risk, you could commit to stop trading after 10 wins or 4 losses, regardless of how attractive market conditions may appear to be or how keen you are to recoup losses.
Binary options traders with a medium risk appetite could tweak this by limiting their trading to 30 winning or 10 losing trades, whichever is reached soonest, while high-risk traders who want to make a fast profit and can afford to lose their trading account could decide to stop at 100 wins or 30 losses.
Cap the amount of money won or lost
Some binary options traders follow a similar approach but instead of limiting their number of winning or losing trades, they place a cap on the amount of money they are prepared to win or lose in one day. These amounts will vary greatly depending on how much trading capital you have as well as your risk appetite.
For example, binary options traders with a medium risk appetite could decide to stop trading once they have either won £75 or lost £25. Very low-risk traders might prefer smaller limits – for example a maximum daily profit of £20 and maximum daily loss of £10. High-risk traders might choose to place no upper limit on their profits but stop trading whenever they have lost £50 in any one trading session.
Cap the number of total trades
Other traders simply decide to limit the number of trades they make each day – for example 10 trades for a low risk appetite, 50 for a medium risk appetite and 150 for a high risk appetite - regardless of whether they win or lose.
All three of these techniques can help create a useful psychological safeguard against reckless or desperate trading – a real danger for new binary options traders in particular.
Cap the percentage of losing trades
Another technique that has a similar purpose is to commit in advance to stop trading as soon as a certain percentage of your trades are unsuccessful.
For example, a binary options trader with a low risk appetite could decide to stop trading once 8% of his trades make a loss. This could be increased to 15% and 25% for traders with medium and high risk appetites, respectively.
This technique is more flexible in that you could in theory make countless trades in one day if you are on a winning streak. For the same reason, however, it can expose you to bigger losses.
So far you have learned that:
- money management in trading can help you achieve smaller but more consistent gains
- binary option traders invented various easy-to-follow techniques to keep their capital safe
- Kelly criterion is a mathematically calculated figure that shows you the maximum amount you can reasonably risk on any one trade
- you can preserve your trading capital by setting certain limits, such as: the number of winning or losing trades, the money won or lost or the total number of trades you take in a trading session
- based on your personal risk tolerance you can make up your own rules on how many loser or how much of a monetary loss are you willing to take in a day