Lesson 9. Management in Binary Options

Risk management is one of the pillars of successful binary options trading. It helps to minimize losses by preventing excessively big losses. Money management is also an equally important factor, but proper management of capital begins with compliance with risks.

Risk management in trading is usually associated with mathematics and diversification. However, it also has a psychological component that many ignore and in some cases it affects the outcomes even more than the technical one. In the final lesson, you will learn the basics of risk management for binary options.

In this lesson, we will address the following questions:

1. What Is Risk Management
2. Psychology in Risk Management
3. Success Factors of Risk Management
4. Risk Tolerance

What Is Risk Management

Risk management in binary options trading is a set of measures aimed at protecting an investor from excessive losses. This is a long term approach to making and implementing decisions that allows for some losses that do not exceed a certain value, so that you have the funds to continue trading.

Risk management enables traders to assess their potential profits and losses, thereby providing them with the information needed for making informed trading decisions. Regardless of the underlying asset you choose and your experience in binary options trading, risk management strategies should be at the root of each investment decision.

Psychology in Risk Management

Risk management involves recognizing the existence of risks. At the same time, the human psyche tends to forget about them. Risk may disturb your peace of mind, causing anxiety in the process. You may already be experiencing high background anxiety caused by problems in your personal life, poor health or any other source of stress. In this case, taking care of trading risks may worsen the situation at times.

The psyche includes protective mechanisms, which are processes that have been forming in our head for years, starting from early childhood and staying with us all the way to old age. They are needed to reduce the severity of negative experiences and find peace of mind. Indeed, anxiety causes unpleasant feelings that you want to suppress. In the meantime, it’s an internal conflict which signals that you need to take some actions.

Our psyche has three main reactions to anxiety:

• Avoiding anxiety (evading);
• Meeting the anxiety face to face (attacking);
• Pretending that there is no anxiety (ignoring).

Similar protective mechanisms are subconsciously used in binary options trading. Novice traders deny the existence of risks or make decisions that are obviously uneconomic, but low-risk. As you might have guessed, a rational decision means exploiting the available resources in order to minimize the risk or prepare for its consequences after occurrence. Let’s consider the main ways to do this.

Determine the Allowable Losses

As mentioned earlier, you have to recognize the existence of risks in the first place. It is necessary to do this in advance, since the brain may not know how to escape this situation at a moment’s notice when emotions are running high. The higher the stress level, the more logical thinking skills degrade.

If the losses turn out to be an unpleasant surprise for a trader, he will not be able to quickly make an informed decision. Therefore, before buying a binary option, determine the amount of money you are prepared to lose in case of failure in advance.

Control the Fear

Do not dwell on an unfavorable outcome as constantly expecting failure may lead to the overestimation of risks and paralyze the entire trading experience. You will have difficulty purchasing new binary options and will not be capable of responding properly and promptly to good signals.

Remember that balance is important in everything. Do not be reckless about the deposit and try to open as many transactions as possible. You should aim to find a balance between greed and fear. Keep a healthy desire to invest, but carefully weigh all the risks.

Trade Consciously

It is not recommended to prepare in advance to give up the funds while trading binary options. This is a wrong mindset that prevents development. You should have an incentive to study the market and to do this, you need to feel the value of winning or losing.

As a result of suppressing the emotion of fear, you’re gradually losing your concentration, and more and more often, you’re draining money for nothing without trying to analyze each transaction properly. As it is easy to guess, such behavior will sooner or later end with the loss of trading deposit.

Raise Deposits Smoothly

When you gain experience and can steadily be profitable, you will want to increase your trading capital. A sharp increase in investments can play a cruel joke on you, triggering a too strong emotional response. Always act gradually to avoid such a situation.

When you are ready to invest large sums, do not rush to double your deposits immediately. Add an additional amount of funds according to certain rules. For example, add $100 every week. Meanwhile, it is important to periodically withdraw your profits.

Success Factors of Risk Management

Effective risk management is about minimizing losses while preserving the opportunity to make a profit. In order to avoid placing too small or too large deposits, train more often on the Pocket Option demo account or in other trading simulators. Be sure to consider the following factors when buying binary options.

Size of a Position

The position size determines how much money you risk while making a single transaction in the binary options market. In no case should it be chosen at random. In order to determine the position size, use a formula and rigorously apply it to each transaction. This is one of the basic rules of risk management in binary options and other types of trading.

Do not invest more than 5% of the total deposit amount in one position. The majority of traders invest only 1% of their capital in each transaction. For example, if you have $500 on your balance, then only $5 should be invested. This rule ensures that even in case of a series of failures, you will have enough funds to continue trading.

Diversification

Different assets behave differently. The high volatility of cryptocurrencies differs significantly from the relative stability of commodities. By investing in different markets, you effectively distribute risks. Undoubtedly, binary options involve risks, so you should diversify your portfolio at the expense of other financial instruments.

Binary options are a fixed-rate instrument, which means you always know in advance how much money you can get or lose on a transaction. You risk only the invested amount. For example, if you purchased an option for $20 dollars, then your maximum loss will be the same $20 dollars in case of failure.

Some platforms such as Pocket Option offer refunds on unprofitable transactions, but this does not apply to everyone, so check this point in advance. Mostly, all invested funds will be lost. By comparing potential profit and possible loss, you can evaluate the risks before opening a position.

Following the Strategy

The interference of emotions within the decision making process is the biggest risk when it comes to trading binary options. While acting on emotions, you multiply the potential losses. Stick to your trading plan and make transactions only with a cool head.

The same applies to following the trends. Never go along with the crowd before studying the market. If you are considering purchasing a binary option, analyze all possible options beforehand and make sure that your decision is not contrary to the risk management principles.

Risk Tolerance

You are simply deceiving yourself when you say that you know your attitude to risk. At the most crucial moment, your behavior on the stock exchange can change like a weather vane on a windy day, and you can’t even notice it. Depending on the results of recent transactions, you can either reduce the risks in case of failures, or increase them after a series of victories.

Most traders follow a riskier strategy and are more willing to purchase extra options when they get unprofitable. And vice versa, after winning, they prefer to avoid taking risks and end the trading day ahead of time. It’s understandable that people are taking profits, but it’s counterproductive.

Hope is not a strategy. Your balance sheet indicators will deteriorate if you allow your risk tolerance to be dependent on the position you occupy. Most likely, you will prematurely take profit, thereby missing a good opportunity to earn money.

Many studies reveal another interesting phenomenon. Let’s assume that you have already made several transactions. Now it turns out that your attitude towards risk will change depending on whether the binary option has made a profit or not.

Possible options:

• After a profitable transaction, you reduce the risks. You predict that the probability of the next winning transaction will be lower than it actually is.
• When the market grows, you gain courage and are ready to take risks again. You overestimate the likelihood of further increases in price.
• After losing several transactions, you will want to recover at least some of the losses at the end of the trading day and will start taking risks too willingly. Consequently, you will want to get your money back and start over-trading.

Successful trading suggests that you are consistent in assessing risks regardless of the results of individual transactions. Your risk management covers the sum of all options. The results of individual transactions do not matter. The only thing that matters is the profit you will receive by the end of the month or year. Take this fact personally and broaden your outlook.

Summary

Background anxiety is an uncontrollable reaction of the central nervous system to certain stimuli.

Defense mechanism is an unconscious process designed to minimize negative experiences.

Diversification means investing in different assets in order to reduce risks.

Risk tolerance is an allowable overall level of loss within a trading strategy, which a trader consciously follows.