Lesson 5. Finding Balance Between Risks and Opportunities

The psychological aspects of trading binary options have the power to either make or break a trader. Developing a strategy considering the risk-to-reward ratio helps to cope with the most dangerous feelings of fear and greed. A well-defined ratio serves as an emotional anchor, preventing impulsive decisions, overtrading and premature exit from potentially profitable transactions.

The risk-to-reward ratio adjusts your actions in the market, turning binary options trading from a speculative enterprise into an effective and consistent tool for earning. In the fifth lesson, you will learn how this ratio can become the basis for making informed trading decisions and achieving financial success.

Lesson Topics:

1. Setting trading goals
2. The risk-to-reward ratio
3. False sense of safety

Setting Trading Goals

We have already discussed earlier that it is important to focus on the process, not on the result. A well-established trading strategy allows you to keep everything under control. Meanwhile, it is dangerous to set a certain amount of earnings as the main goal, because the trader has no real control over the market. The amount of potential profit does not always depend on you.

Your priority should be to analyze trading processes, but it's equally important to weigh up the desired profits and acceptable losses. After all, you want to make money from trading in the first place. Despite the fact that a lot does not depend on you, you should not forget about the permissible losses and the target profits.

Ask yourself the following questions:

• How long do you want to achieve your profit goals?
• How do you determine the risk-to-reward ratio for each transaction?
• What profitability do you want to achieve in a week, month and/or year?

Set a realistic amount of money as a target and plan everything down to the smallest detail. It is worth sticking to the following rules:

• Evaluate the risks and potential profits every time before opening a transaction;
• Go through all possible scenarios in your mind;
• Know exactly what you will do if the market situation unfolds not in your favor.

Risk and Reward In Binary Options Trading

Binary options are a relatively new investment tool, but over the past few years this market has significantly expanded. The low cost of Internet connection, the absence of strict restrictions and the simplicity of trading contributed to the exponential growth in the popularity of electronic contracts.

Unfortunately, the high potential profit from binary options trading (70% profit for one successful transaction is quite a common phenomenon) sometimes makes novice traders forget about the high risks of this market. Before you start trading, you need to thoroughly understand the features of the risk-to-reward ratio.

Unlike conventional options that are traded on stock exchanges, when trading binary options, the percentage of profit is fixed. This indirectly reduces the chances of the trader. In order to understand whether this statement is valid, it is important that you have a good understanding of the two main ratios which determine the outcome of trading on all financial markets.

They include:

1. The risk-to-reward ratio. This is the ratio between the potential risk and profit in each specific transaction. Ideally, professionals advise you to look for trading installations with a risk-to- reward ratio of 1:2.
2. The ratio of profitable transactions to unprofitable ones (win rate). This percentage ratio reflects the probability of a positive outcome on the option and is calculated based on the results of previous activities. It is found by dividing the number of winning transactions by the total number of transactions made over a certain period.

The Risk-to-Reward Ratio in Binary Options

Trading platforms often lure potential customers by indicating the interest rate of a successful transaction. You should understand that high profits also include high risks. If a trader loses a transaction, he loses all invested funds (except for possible compensations). Therefore, the potential risk is 100% of the investment amount, while the interest rate ranges from 65% to 92% (depending on the broker). Simply put, the risk-to-reward ratio is not even 1:1.

Suppose a binary options broker that offers a profit of 80% for any transaction that ends “in-the-money.” If the option ends “out-of-the-money,” the trader will lose all the investment. In this case, the risk-to-reward ratio is 1:0.80. For every dollar invested, the trader gets only 80 cents in case of a successful transaction, and in case of an unsuccessful course of events, all the money will be lost.

Thus, provided that the risk-to-reward ratio remains unchanged, more than one transaction will be required to recover the lost amount. Obviously, the trader's chances for success are not as great as it might seem at first.

Next, if we assume that the ratio of profitable transactions to unprofitable (win rate) is 60% and the trader invests $100 in each transaction, then the income from 10 options will be as follows:

• Number of winning transactions = 6
• Number of losing transactions = 4
• Net income = $80 × 6 – $100 × 4 = $80.

If the win rate is less than 50%, then there is a loss of capital:

• Win rate: 40%
• Winning transactions: 4
• Losing transactions: 6
• Net loss = 4 × $80 – 6 × $100 = -$280.

Let the ratio of profitable transactions to unprofitable ones be 50%, and the reward for each successful contract is 80%. At this point, an average trader will not earn anything from the first 10 transactions.

False Sense of Safety

Frequently, brokers offer refunds on transactions that the trader has made. When the transaction ends “out-of-the-money,” the investor receives a refund to his account in the amount of a certain share of investments, such as 15%. Such offerings create a false sense of safety in the trader's mind.

However, the fact that the remuneration for any transaction completed “in-the-money” is comparatively less than the profitability (in the case of a winning transaction) from offers without compensation remains unnoticed. So is it actually a profitable offering that affects the risk-to-reward ratio? Let's evaluate it with a specific example.

Suppose a broker offers 65% remuneration for profitable transactions and 15% return on unprofitable ones. With a ratio of profitable to unprofitable transactions of 60%, the profit from 10 transactions
concluded with investments of $100 each will be:

• Total number of transactions: 10
• Losing transactions: 4
• Winning transactions: 6
• Net income: (6 × $65 – 4 × $100) + 4 × $15 = $50.

When compared to the situation discussed earlier, the net income actually decreased despite compensation. The broker's offering seems attractive, but in the end the risk-to-reward ratio remains in favor of the broker.

How to Improve the Risk-to-Reward Ratio

As the risk-to-reward ratio is fixed, the trader has only one way of selecting a reputable broker that offers the highest return for a successful transaction. Meanwhile, the conditions should be simple and not too different from the usual offers on the market.

Conscientious trading platforms allow clients to exit the transaction before the option contract’s expiration period. The client can save part of the invested funds due to early closing if the price starts to move against the position taken. For example, Pocket Option provides an opportunity to cancel transactions even with a short expiration period, when you will instantly return the money. Since you can do it at any time, the risk-to-reward ratio is no longer fixed. This opportunity is especially useful for experienced traders who are able to quickly identify even a slight change in the direction of price movement.

Some brokers offer up to 500% profit for transactions that end up being “in-the-money.” However, following the conditions set for obtaining such an amazing profit is an almost impossible task. Complex requirements ensure that the number of losing traders will be multiple times more than the winners. In other words, the broker will not be in any danger of losing money.

Therefore, a trader can earn steadily on binary options trading if the following conditions are met:

• Selecting a reliable broker that offers high rewards for successful transactions (an adequate risk-reward ratio).
• Using an effective trading strategy with a high ratio of profitable trades to unprofitable ones.

No one is able to make 100% accurate financial predictions. The stock, Forex and commodity markets are very dynamic, where complex patterns can form in a short period of time. All this together with high volatility increases the entry threshold into binary options.

The risk-to-reward ratio in favor of the broker hinders even professional traders from earning steadily. Therefore, it is incredibly important to evaluate this ratio every time before making a transaction. If you do not pay due attention to this ratio, you will quickly lose your capital.

Finding Balance Between Risks and Opportunities

The risk-to-reward ratio has nothing to do with the probability of your transaction’s success. It only shows your potential profit you can expect by risking one dollar, provided that you achieve your profit goal. In order to be profitable in the long run, it is necessary to strive for a win rate of 50%. Alas, but only a few traders manage to continuously close more than half of the transactions with profit. Therefore, profitability must be controlled by a sufficiently high risk-to-reward ratio. You should consider the relationship between this and the winrate.

The higher the risk-to-reward ratio, the lower the win rate. In other words, if the profit target is set too high, then the probability of achieving it will be relatively low. It is irrational to hope to achieve a ratio of 10:1 as it is unlikely that such profitability can be achieved at all.

Be out of the clouds and set realistic goals for yourself! Price targets should be adequate, and not reflect your fantasies.

Remember that only those probabilities determined by the market work in trading. Some traders have a too strong temptation to deceive themselves. Mistakes in their reasoning happen involuntarily.

Such traders plan a transaction and increase the target profit level until they get the best ratio, even if the probability of reaching that price target is extremely low. Moreover, some people increase the subsequent transaction’s target to compensate for losses. They start to fight the market by engaging in so-called vindictive trading in the hope of returning the lost money.

In the above-mentioned cases, market mechanisms are completely ignored. The trader no longer follows the market, but manipulates the risk-to-reward ratio. This approach is counterproductive.

You should focus on realistic ratios for each transaction depending on the market situation and the chosen trading strategy. Successful traders open positions with low risk and relatively high profit opportunities.

Summary

The risk-to-reward ratio is a coefficient that shows the ratio of risk to the amount of potential profit.

The ratio of profitable and unprofitable transactions is a coefficient that is found by dividing the total number of profitable transactions by unprofitable ones for a certain period of time.

Vindictive trading is an attempt to recover losses from an unsuccessful transaction by instantly opening another position without a clear strategy or plan.