Risk management is an important component of any successful investment strategy.
When dealing with binary options, there are a number of measures that investors should bear in mind. An effective strategy integrates prudent risk management techniques so as to ensure that you are exposing yourself to substantial upside while limiting the amount that you can lose in any given contract. In this article we investigate several aspects of controlling for risk in the context of this form of speculation.
Instruments offering limited risk exposure
By design, this form of trading exposes investors to a limited amount of risk. The amount that you can lose in any given trade is known before the trade commences, so regardless of the degree to which your contract is ‘out of the money’ at the time the option expires, you are not going to lose more than you bargained for.
This is in stark contrast to the risk dynamics of dealing with traditional foreign exchange contracts, because in those contracts you can end up losing much more than the size of your initial position. The use of contracts-for-difference and other forms of leverage offer the promise of higher returns, but they also present investors with the very real possibility of being completely wiped out if markets turn in an unfavorable direction.
Advanced risk management features
Several of the leading binary brokers provide a set of advanced option features that enable investors to take greater control of the outcome of an options contract, thereby providing greater means through which investors can control their risk exposure. One feature in particular, sometimes referred to as ‘Sell’, enables investors to exit a contract early in cases where the contract looks as though it will expire ‘out of the money’.
The use of such advanced option features is typically not free, however, they do provide a great way for investors to cut their losses and thereby limit the amount of risk that they are exposed to in any single options trade.
Optimal position sizing
Another thing that investors should bear in mind when seeking to manage risk is position sizing.
Typically investors should not invest a very large proportion of their available trading assets into a single trade. The reason for limiting the size of any single trade’s position is this: by putting too much capital on the line, if the trade goes against you there is a reasonable chance that you will be wiped out entirely and will therefore be unable to recover from one poor-performing trade.
The best way to overcome this form of risk is to carefully calculate the amount that you are willing to invest in any given trade, and to not deviate from this pre-determined level.
The exact proportion that you should invest in any given trade will depend in large part on your appetite for risk, but a general rule of thumb, regardless of whether your account is several hundred, several thousand or even several million dollars, is to not allocate more than 10% of your account to a single trade.
Investors seeking to generate consistent returns should take measures to ensure that they are not taking on more risk than they can afford to. This form of trading is by design a great way to avoid taking on more downside risk than you can afford to.
Additionally, by taking advanced of advanced ‘early contract exit’ features and by carefully sizing all positions, investors can meaningfully improve their risk exposure.
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