Binary options are inherently very risky. The contracts have no intrinsic value per say. When you lose, you lose 100% of your position, and when you win, you can win big. To a new trader, binary options can feel a lot like gambling. Trading binary options is not the same as gambling, but if you don’t know what you are doing it is as least as risky. Remember, the advantage of using binary options is that you do not need to trade with a lot of capital to earn a high return. Respect how quickly you can both earn and lose a lot of money trading this instrument.
Think about binary options trades from a broker’s perspective. Binary options trades are not matched between buyers and sellers on the open market, the broker always takes the opposite side of the position from the trader. Why is the broker willing to do this? They know that if a particular trade pays 80% to a winner, and a losing trade loses 100% of its value, with nonprofessional traders about 50% of the trades will pay out and about 50% will not. This means that the broker earns a spread of 20% on the trade, on average across all traders.
If you start trading with no system, you will probably win on about 50% of your trades and lose on about 50% of your trades. If every trade is the same size, you will certainly lose your money over time. Always keep in mind when you trade binary options that you need to win more than you lose to make money.
Controlling Position Size
A common mistake with new traders is taking too large of a position size too quickly. As any trader will tell you, things change fast in the marketplace. Even if you have a good system with a perfect trade setup, and you have very high conviction about taking your trade, the news can change the market quickly and turn your trade from a winner to a loser.
Keep in mind that a loss is not the same as a loss when you are trading in the stock market. If you lose money on an equity position, your position still has value when you exit it. This is not true of binary options. If your trade is a loser, you lose the entire amount of your trade. This is why you need to take positions which are a very small percentage of your total account balance. The only way to consistently make money is to systematically control your risk, and take enough good trades to win over time.
What is A Small Enough Position?
If the idea is to make money with binary options consistently over time, you need an average position size which equals a very small percentage of your account. If by chance you have 5 losses in a row, and you are using a position size that is equal to 20% of your initial account balance, you will empty your account in only 5 trades. As any professional trader can attest to, losing streaks of 5 trades can happen to anyone.
At How We Trade, we recommend using a position size of about 5% of your initial account balance (you can review this if you are profitable and your account has grown). At this size, you could take 20 consecutive losing trades before your account balance was 0 (its safe to say that if you have 20 losing trades in a row you need a new system).
This position size allows for small losing streaks to occur without serious disruption to your working capital. By nature the balance in your binary options account will be volatile. It is the traders job to smooth out the volatility by taking many small sized positioned trades.
When Is a Big Position Justifiable?
Depending on who you are, how much of your money is in your trading account, and how much experience that you have trading, the answer may be never. There is a particular case when it may be ok to take a large position though.
If you have a lot of experience trading, and if you were to lose the entire amount in your trading account your personal finances would not be seriously impacted, a large position from time to time is ok. A large position might be a once a year or less type trade for many people.
To take a very large position you must have extremely high conviction that the trade will work. This does not mean that the trade definitely will work, because no trades are a sure thing, but the trade setup must be almost perfect. If you study international monetary policy for instance, and you do not think that current exchange rates have fully priced in a central banks stated goal, you may take a longer term foreign currency exchange trade with your binary options account with a large position.
The key is to exercise discretion here, and understand that the market is a very difficult place to extract profits consistently. Most traders are very well served to put strict limits on their position size for the safety of their account.