Cheat Sheet 7: Managing The Risk In Your Losing Binary Options Trades
The stock is moving against you, quick, what do you do? This situation is inevitable; it is how you deal with these situations that will determine whether you will become a profitable binary options trader. In last week’s lesson we discussed hedging strategies to alter the risk profile of binary options trades to something more favorable than the average 70% return for a winning trade and 85% loss for a losing trade. The main assumption in last week’s strategies was that the option purchased had to be in the money prior to expiration. However, we all know that we are not always going to be correct in picking the initial direction of the underlying asset, and thus our binary option position may be out-of-the-money when looking to hedge. So what can you do when your binary option position is out-of-the-money to manage risk? Before we dive into the specific strategies to consider in instances like this we need to step back and address a larger question: How much are you willing to risk per trade for the chance to generate positive returns?
The trade amount, lot size, is extremely important when developing your binary options strategy. Determining how much you are willing to lose per trade will ultimate determine how you size your trades both initially and when looking to hedge. For instance say you are comfortable with the potential to lose $85 on $100 trade; in this example we would suggest placing $50 trades (half of your comfort level price) for your initial trades. This lot sizing will provide flexibility when managing your trades.
So the question remains, what should you do if the option you purchased is out of the money and the lockout period is minutes away?
1) Walk Away: Since you properly lot sized your trade, one option (no pun intended) would be to essentially fold your hand, and turn your attention to another opportunity. You were comfortable with losing $85 on a $100 trade; instead you take a $42.50 loss and live to fight another day.
2) Buy another option: Making another trade on an out-of-the money option seems risky on the surface, but since you properly lot sized your trade at the outset, the risk of loss would still be within your defined comfort zone. In the graphs below we demonstrate the projected payout on a binary option position in which we buy the same type of option (call/call, put/put) on the out-of-the-money position (top) and one in which we buy the opposite type of option (call/put, put/call) on the out-of-the-money position (bottom):
As can be seen there still exists a way to ultimately profit when purchasing the same type of position (call/call, put/put) but the stock would need to move a relatively far distance in order for this to occur. Buying the opposite type of option (assuming equal lot sizes) effectively locks in a loss, as both positions cannot end up in the money. Either you take a relatively small $7.50 loss if one option ends up in the money or you take the full $85 loss if both positions finish out of the money. Getting comfortable taking small losses on bad positions will ultimately make you a much better trader.
3) Purchase 2 additional options: This strategy piggybacks off of the second strategy above in the sense that you’ve made the decision to not walk away and have already bought another option. Assuming the stock moves in such a direction that one of your options is now in the money, instead of settling for one of the risk profiles highlighted above, you now have another alternative: lock in a ‘profit zone’ range on your in-the-money option by purchasing a third option. This third option purchase actually lowers your max potential loss amount and creates a profit zone much closer to the current stock price than the one highlighted in the first above. This ‘N’ strategy is illustrated below: