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Binary Options Risk Management

Written By

William Berg

Written By

William Berg

William contributes to several investment websites, leveraging his experience as a consultant for IPOs in the Nordic market and background providing localization for forex trading software. William has worked as a writer and fact-checker for a long row of financial publications.

» William Berg Profile Page

Edited By

Tobias Robinson

Edited By

Tobias Robinson

Tobias is a partner at DayTrading.com, director of a UK limited company and active trader. He has over 25 years of experience in the financial industry and contributed via CySec to the regulatory response to digital options and CFD trading in Europe. Toby’s expertise and dedication to financial education make him a trusted voice in the industry, including a BBC investigation into digital options.

» Tobias Robinson Profile Page

Updated

May 31, 2024

Trading binary options is not for the faint-hearted. But for those starting out, learning how to manage risk is key to achieving success. In this guide, we talk all things binary options risk management, from tools and strategies to brokers and more. Find out how to manage risk when trading binary options.

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What Is A Binary Option?

A binary option is a financial product that has just two payoff outcomes: a fixed sum or nothing at all. They are one of the most straightforward financial assets to trade, which has resulted in widespread appeal, particularly among novice investors.

But their deceptive ease should not be underestimated. Binary options are volatile assets so learning how to effectively manage risk is key to achieving consistent results.

Binary options are also known as all-or-nothing options, digital options and fixed return options. They differ from traditional options; they have varying fee structures, risks and payouts, as well as individual liquidity structures.

Risk Management Basics

Binary options risk management can be defined as a series of measures put in place to protect a portfolio against overwhelming losses. It is a long term approach to security, ensuring that traders can incur some losses but that no single loss is so great that they are unable to continue trading binary options.

An effective risk management approach enables you to evaluate prospective gains and losses, equipping you with the information needed to make informed trading decisions. Whether you are a professional trader, newbie, swing trader or day trader, risk management strategies should underpin all investment decisions.

Binary Options Risk Management Strategies

Effective binary options risk management is about minimizing losses whilst ensuring there is still something to gain. You do not want to be so conservative that you stand to make insignificant profits. Equally, you do not want to put so much on the line that should a trade not come through, you are left unable to trade in the future, or worse, incur debts that you will struggle to pay off.

Position Size

Your position size will determine how much you risk on a single binary options trade. Importantly, the amount you invest should not be chosen at random. View position size as a formula and apply it to every trade. This is a key tip when considering binary options risk management.

The 1% rule is a widely used approach that states that you should not risk more than 1% of your total capital on a single binary options trade. For example, if you have $1000 in your account, you would invest just $10 in a single contract. This is to ensure that, should the position not payout, you are left with enough capital to continue trading.

Experienced traders may increase this percentage over time, but as a rule, it should never exceed 5% of your portfolio.

Diversification

Assets and markets behave differently. The volatility that accompanies forex trading differs greatly from the relative stability of commodity trading, for example. By investing in a range of markets, you effectively ‘spread’ risk. In the event that prices fall significantly in one area, you can fall back on your other assets, that hopefully have not been affected in the same way, or to the same extremes.

Binary options are obviously risky products, therefore, we recommend diversifying your portfolio with CFDs, spot stocks, or leveraged commodities, for example.

Quantifying Risk

Binary options are fixed-outcome instruments which means that you know in advance how much you stand to gain or lose. The risk is the amount you place or ‘wager’ on a trade. If you deposit $10, your maximum loss will be $10, for example.

Some brokers offer rebates on losing trades but this does not apply to all, so ensure you check that in advance. Importantly, because you know how much you stand to gain or lose, you can understand your risk exposure before entering positions.

When looking at binary options risk management you should always imagine the worst-case scenario. Calculating your position size is a quick check to do and can help keep you on track, especially when actively trading. As you trade more, you may decide to increase or decrease your position sizes in line with your risk appetite.

Trade Strategically

One of the greatest risks is to let emotions interfere with your strategy. Trading binary options based on emotion leaves you liable to making rash decisions. Stick to your plan, trust in the logic and keep your emotions in check (of course, this is easier said than done). The same can be said for following trends. Your risk appetite will differ from those around you. Stick to your guns, know your limitations and trade within in it.

Whilst not a formal binary options risk management technique, consistently keeping a handle on your emotions is a useful tip.

Risk & Regulation

Owing to their high-risk proposition, binary options are regulated and also prohibited in some major global markets.

Binary options can be traded on central exchanges in the US via the North American Derivatives Exchange (NADEX) and the Chicago Board Options Exchange (CBOE). Nadex was the first legal US exchange that permitted binary options trading.

Non-US binary options tend to have fixed payouts and risks and are offered by individual brokers, in place of centralized exchanges. Whilst there are some exceptions, most options are held until expiration in an ‘all-or-nothing’ payout structure.

Importantly, retail binary options are banned in some markets, including the UK and Europe. As a result, traders will need to turn to offshore providers. This makes it increasingly important to open an account with reliable and trusted platforms. See our list of reputable binary options brokers here.

Binary Options Risk Management Tips

We’ve collated our top tips for managing risk when trading binary options:

• Use the 1% rule
• Separate your emotions
• Follow a trading strategy
• Diversify your investment portfolio
• Utilize risk management calculators
• Keep a trading plan, for example, in Excel
• Leverage electronic risk management tools
• Focus on long-term results versus short-term trading profits

Final Thoughts

Binary options trading is not for everyone. But for those in a position to take the risk, binary options present a real opportunity to generate substantial returns, even on a flat market. To get started, make sure you follow binary options risk management best practices, including the 1% rule and diversifying your portfolio. See our tips above to start trading.

FAQs

Is Binary Options Trading Suitable For Newbies?

Binary options trading is risky. However, if beginners can take a sensible approach to risk management, they may see profitable results. Check out books, PDFs, forums and online guides for more tips on binary options risk management.

Is Binary Options Trading Safe?

Trading any asset involves a degree of risk. Effectively managing that risk is the key to making something as safe as it can be. See our guide above for risk management tips and techniques to get started.

Is Binary Options Trading Gambling?

Some commentators liken binary options trading to gambling owing to the high stakes involved. But arguably you could say the same with anything that involves a degree of risk. What makes it a form of investing is the approach taken by traders, i.e. do they follow binary options risk management techniques?

Is Binary Options Trading Legal?

Yes, binary options trading is legal in some jurisdictions, including the US. With that said, retail binary options trading is banned in the UK and Europe, amongst others. This means investors will need to open accounts with offshore providers. See our list of the top binary options brokers to get started.

Is Binary Options Trading Different To Trading Forex?

Whilst binary options are a specific financial product and forex is a particular market, there is overlap. Binary options can be traded on popular currency pairs, including EUR/USD, GBP/USD and USD/JPY. Importantly, a careful approach to risk management should be taken to prevent big losses.