Binary Options Risk Management

For traders seeking to increase their chances of long-term success, binary options risk management is key. Introducing risk management to your strategies can be a simple task, however, you need to ensure you understand how each measure works and how it will impact your trading. This guide will consider why it is important and explain some potential methods of including risk management in trading binary options.

Binary Options 101

Binary options are a type of derivative, whose value derives from and is dependent on the value of an underlying asset. You predict what the price of an underlying asset will be relative to a strike price at an expiration time.

To open a binary options contract, you must stake an initial investment. Typically, returns are between 70-90% of this stake, however, brokers sometimes offer a greater profit percentage depending on the asset and the type of trade.

There are several different types of standard binary options contracts:

• High/Low – Predict whether the asset’s price will be greater or lower than a strike price when a contract expires
• Touch/No-Touch – Predict whether the asset’s price will reach or reduce to a strike price before a contract expires
• Boundary – Predict if the price of an asset will be between or outside of a given range at the expiration time of a contract . This is also known as range or tunnel binary options.

Example

At 10 am, Lloyds stock (LLOY.L) is valued at 42.62p.

A broker is offering a 75% return on a high/low binary options trade, with an expiry of two hours.

At midday, LLOY.L is trading at 42.93p.

If you staked £20 to open a call (high) binary options contract with a strike price of 42.70p, the broker would return £35 (£20 stake + £15 profit).

If you had instead placed a put (or low) binary options trade with the same stake and strike price, you would have lost your initial investment (£20).

What Is Risk Management?

No trade is ever without risk. There is always a chance of something going wrong, resulting in a loss. This is particularly so with a derivative as you never actually own the asset. With spot trading (the purchase or sale of a stock, foreign currency, crypto or commodity for immediate delivery), even if the asset decreases in value, you still own the security and can wait for its value to increase again.

Risk management, as its name suggests, refers to the techniques or measures implemented by traders to control the potential losses in a trade. More specifically, risk management in trading binary options is important due to their ‘all or nothing’ nature, whereby any trades ending out-of-the-money (meaning an option has no intrinsic value) result in the loss of the entire stake.

Risk Vs Reward

One key aspect of binary options trading risk management is risk vs reward. Consider this analogy. A colleague asks you to lend them £10 with the promise of returning £15 a few days later. For a potential reward of £5, this may not seem worthwhile. However, if they instead promise to return £30, the proposition is a lot more appealing and you may be willing to accept the risk due to the higher reward. You can apply the same risk vs reward premise to binary options trading.

Calculation

The risk/reward ratio is calculated by taking the possible net profit from the trade and dividing it by the total potential loss. This tells you the ratio of the potential profit per GBP that you risk. In the above example, the risk/reward ratio for the first proposition is 1:0.5 (risk £1 for every £0.50 of profit). In the second, more favourable proposition, the risk/reward ratio is 1:2 (risk £1 for every £2 profit).

Let’s use an example with binary options:

A broker offers a binary options trade on Tesco (TSCO.L) with an 80% return. You stake £50 on a call (high) binary option. The potential returns for this trade are £90 (£50 stake + £40 profit). The risk/reward here is 1:0.8 (risk £1 for every £0.80 profit).

If instead, you use a hedging strategy with two binary options such that one will always be in the money (an option that presents a profit opportunity due to the relationship between the strike price and the prevailing market price of the underlying asset), the risk/reward ratio could be instead 1:8 (risk £1 for every £8 profit).

The benefit of calculating the risk/reward ratio is gaining a quantifiable measure of how risk management strategies can help you.

Why Binary Options Risk Management Is Important

If you were to speak to an experienced trader, they would likely say that risk management is one of the most important aspects of active investing. Without risk management strategies in place, you can easily find yourself losing the funds you have deposited into your brokerage account. While applying a binary options risk management strategy could reduce your total possible profit, the benefit you gain by reducing the total loss per trade often makes it worthwhile.

A report from The European Securities and Markets Authority (ESMA) on binary options trading found that, across three firms offering binary options to retail traders, less than 30% of customers saw positive cumulative returns. This demonstrates clearly how difficult it is to find sustained success when trading binary options. Importantly, it also highlights the need for a considered approach to risk management.

How To Manage Risk With Binary Options

There are many ways to introduce risk management in binary options trading, be it that the underlying asset is forex or commodities. Consider researching each method to find which is best suited to your trading style. Keep in mind that the following strategies will not necessarily remove all risks involved though they may help to reduce them.

Diversify Your Trading

By diversifying your portfolio, you can spread your capital across several smaller investments rather than staking large portions on one or two trades. By doing this, a single trade ending out-of-the-money will have a reduced impact on your portfolio. This is particularly important if you want to place binary options trades with highly volatile assets such as cryptocurrencies as there is a greater potential for sudden swings.

Hedging

Hedging is a popular day trading risk management strategy for binary options. It works by opening two binary options contracts on the same underlying asset, both of which expire at the same time. One is a call (high) and the other is a put (low) – a call option gives the holder the right to buy an asset and a put option gives the holder the right to sell the asset.

The key point here is that the strike price for the call contract is lower than the strike price of the put contract, in essence creating a boundary binary options trade. Given how these are structured, at least one contract will always end in-the-money and therefore reduce the total losses you could make.

Let’s consider an example of how hedging with binary options works:

A broker offers a binary options contract on NatWest Group on the London Stock Exchange with a return of 80%. You stake £100 on a call with a strike price of 218.50p with an expiration time of 11am. As the price of NWG.L at 11am is below this strike price, you would lose the entire £100 stake. However, if you had also opened a put contract with a strike price of 219.50p, the net loss would be £20. This is because the put contract would end in-the-money and return a profit of £80, offsetting the £100 lost from the call contract.

If NWG.L was trading between 218.50p and 219.50p at 11am, both contracts would end in-the-money and you would have made a profit of £160.

The image below shows the NWG.L price history chart with indicators for how each contract could end in-the-money.

The One-Percent Rule

This method of managing risk is a strategy where you limit your investment on a single trade to only one percent of your funds. For example, if you have £1,000 deposited with your broker, you would only stake £10 on a binary options trade.

This is popular with day traders due to the high frequency they execute trades, however, it can still be used for longer-term trades such as swing trading.

The main benefit of this strategy is greater protection from losing large portions of your funds on a single trade that fails.

Emotions

This is not a strategy per se but a way to control and reduce unnecessary risk exposure. Being disciplined and not reacting emotionally to a potential trade, means you stick to your trading strategy and avoid rushing into a trade without completing thorough technical analysis and research.

To help with binary options risk management consider laying out your strategy and reviewing your performance by logging trades in books, journals or software such as Excel. If you regularly reflect on the trades you make and why you make them, you can learn to exclude excessively risky trades.

Bottom Line On Binary Options Risk Management

Learning how to include binary options risk management in your trading should be a priority when you register with a broker. It is important you understand the available tools and how they can be implemented into your trading activity. You could also try reading books, PDF guides and tutorials on risk management in trading binary options to boost your knowledge.

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