Managing risk is a huge subject, and it is impossible to cover completely in a single blog, or even a hundred blogs. But even if we look at it on a limited basis, risk is important to address. It impacts everything you do when you’re trading, and if you know what to expect, you have a better chance of successfully addressing risk. This is one of the reasons why you are probably drawn to binary options trading; you can see what your risk is before you execute a trade. This is a good start, but it’s not enough. Here, we will give you a brief introduction to some of the things that you need to know.
First, know that you can’t avoid risk when you’re trading. You can reduce the amount that you take on, but there’s always a chance that you will lose money. Your job as a trader is to work around the risk, acknowledging that it exists and doing your best to make money despite risk. You will have losing trades, and you will have them often. Instead of letting this eat away at your trading account, you need to ensure that you have enough in terms of profits so that your losing trades are more than offset.
Introducing Expected Value
Because you can’t avoid risk, you need to know as much as you can about it so that you can compensate for it. So, in addition to your knowledge of risk, you also need to know what your chances of success are. For the sake of simplicity, we can combine these two terms with one powerful concept: “expected value,” or EV. This is a concept that is very popular in the world of finance because it helps you to better understand the impact that a single trade can have on your profits and losses. It strips away the high rates of return that binary options offer, and shows you what a trade is really worth.
EV approaches something that your risk rate or correct trade rates alone cannot. It takes variance into account. Variance is that untouchable quality of uncertainty. Let’s say you know that you are making the right choice when you pull the trigger on a binary options trade, but suddenly, at the very last minute, prices fluctuate and your trade is a loser. You didn’t make a losing trade because your analysis was wrong, but because of the last minute fluctuation that occurred. This is the concept of variance at work.
EV accounts for variance by addressing your trading on a large scale. Rather than look at the results of just one trade, it looks at what would happen over the course of 100 trades, or 100,000 trades. This helps you to quantify what the right decision is, and how much of a return you should expect if you made the same trade with the same conditions over a huge number of instances.
Let’s dig into some math to help us better understand this. Let’s say you are making a 15 minute trade on the USD/JPY. The broker you are using offers a 78 percent rate of return. If you risk $100 and your correct, you earn $78. If you’re wrong, you lose $100. You determine that you are going to be correct with your trade 60 percent of the time. When you convert this to EV, what is this trade worth?
The easiest way to do this is to look at 100 hypothetical trades. You will be right 60 times (if your prediction is correct), and profit $78 each time, for a profit of $4,680 (60 x $78). You will lose $4,000 (40 x $100), bringing the total profit over 100 trades to $680. Now, you are looking at one trade, so take that $680 and divide it by 100 trades, and you can determine that the expected value of this one trade is $6.80.
That’s a big difference from the $78 you would profit on one successful trade. However, by breaking this down in terms of EV, you can see whether a trade is worthwhile or not and you can better manage your money and your risk. Luckily, in the above scenario, we see that this trade is going to make us money over the long run. Even if we are wrong with this trade ten times in a row, we can quantify and justify our losses, knowing that over the course of time, we will make money. What if you find yourself dipping down in EV, though? Is it worth it for you to make the trade if your EV is $2 per trade? What if it’s $1? With this line of thinking, we can pick and choose which instances are most beneficial to risk our money on. At a certain point, you will find that a trade just isn’t worth making.
Quantifying Risk Wrap Up
This might be a common-sense thing to wrap up with, but when you address EV and start looking at it for yourself you need to keep two things at the front of your mind. One, a -EV trade is never worth making. Even if you are lucky and get the prediction right and make money, over the course of time you will lose money on these trades. Avoid them. And two, you need to be honest about your chances of success. Most of the time, your odds of success will not be as high as 60 percent. They are more likely to gravitate between 45 and 55 percent. Evaluating this number will become easier and more accurate over the course of time, but it’s important not to sugarcoat this. If you do, you will be evaluating your likelihood of success with a skewed point of view, and you will dip into -EV trades unknowingly, losing a lot of money as you go. This is another thing that you will definitely want to steer clear of. Good risk management will help you to earn more money, but it requires you to look at each trade honestly.