Binary Options without doubt provide one of the simplest approaches to financial trading that you will find. However if you want to make money from them it is important to look beyond this and spend some time analyzing the all important risk to reward ratio that these contracts offer.
The dazzling returns that brokers highlight combined with the simple trading mechanics that binary options offer, leads many individuals to overlook the underlying risks inherent with this style of trading.
This is not the fundamental or technical risk which forms part and parcel of any method of trading. Instead it is the risk versus reward ratio that is built into every contract. This stacks the odds against the trader before a contract is even purchased.
Two key variables exist that need to be considered when making an assessment of the profitability of a trading method. These are the ‘risk to reward ratio‘ available on each trade and the overall ‘win loss ratio‘ of the binary options strategy used.
Here is a brief description of each:
Risk to Reward Ratio – This potential return versus the potential loss on each trade taken.
For example, if a contract was taken offering a 100% return where the entire investment would be lost if the contract ended ‘out of the money’, then the ratio would be expressed as 1:1. If the return was 200% (loss would be 100%) then the ratio would be 2:1.
Win Loss Ratio – This shows the number of winning to losing trades positions of the total number of trades placed by the strategy expressed as a percentage.
A win to loss ratio of 50% would mean that half the trades taken had ended ‘out of the money’ while the other half had ended ‘in the money.’
The ‘Win to Loss’ ratio is also sometimes referred to as the ‘Strike Rate‘.
The Odds Are Against You
The biggest obstacle to trading success is that most individuals will focus on the high returns on offer without examining the probability of success of achieving consistent returns. It is of course easy to get seduced by advertising offering the chance to earn returns of 70%+ in a matter of minutes.
However while this may be ‘headline’ grabbing and set the scene for a potential rapid increase in wealth, it distracts from the underlying mechanics of binary options which see the odds stacked against the trader.
Let’s take a closer look at the risk to reward ratio and strike rate. It is how these two concepts work in tandem which is significant in determining how profitable our trading will be.
Let’s start by looking at a risk to reward ratio of 1:1 and a win loss rate of 50%. The profit and loss on each trade would be the same and we would win the same number of trades as we lost. Our balance would move up and down but the law of averages over time dictate that our account will always return to its starting level.
Of course we actually want to make money. Therefore to make our approach profitable we would need to either 1) increase the risk to reward ratio on each contract or 2) increase the win rate of the strategy. Either one of these would set the strategy on the road to significant long term profits.
The problem with binary options is that it is very difficult to increase the risk to reward ratio because the return is fixed.
With ‘spot’ trading in the markets you can set your own price targets and stop levels dependent on the merits of each trade. This can yield some very favorable profit to loss ratios. However this is not achievable with the fixed returns in binary options.
Let’s assume a return of 75% that a typical binary options broker might payout for an in-the-money higher/ lower contract. With no rebate available on this contract our risk to reward would be 0.75:1.
This is actually lower than the 1:1 used in the example above. This puts us at a distinct disadvantage from the outset. A trade that wins no longer covers a loss. Immediately you can see that to compensate we need to increase our strike rate above the 50% level just to compensate and keep our example at break even.
A good illustration as to how this effects returns is to look at the following example of 5 $100 trades. Here we assume that 3 ended in the money and 2 ended out of the money.
The first example assumes a theoretical 1:1 ratio that we used in the example above. The second uses the 0.75:1 ratio which is more representative of the returns available from a typical broker.
- 1:1 Ratio (100% return) Profit ($100*3) – LOSS ($100*2) = $100
- 0.75:1 Ratio (75% return) Profit ($75*3) – LOSS ($100*2) = $25
As you can see the real world example does make a profit; but only just. In fact it is important to note that the strike rate of the strategy in this example is actually 60% which is actually significantly higher than the 50% used in the first example (see here to calculate the win loss ratio).
The purpose of this example is to highlight how significant the return on each contract is to overall profitability. We can see that by stacking the risk to reward ratio against the trader, the broker can make it significantly harder for the trader to attain profits.
How Can You Improve Risk To Reward?
Many people make the mistake of confusing the individual ‘risk to reward’ on a contract with the win ratio of a strategy. While they are intrinsically linked when it comes to determining the profitability of a strategy, they are distinct entities that need to be addressed individually.
There are few steps that you can take to improve your risk to reward with binary options as you are limited to what binary options brokers are prepared to payout on a contract.
Choosing a binary option broker that offers you a high payout will help to move the odds in your favour. For example, earning an 89% payout opposed to a 70% payout for the same contract will go some way to moving the risk to reward ratio in your favour.
Remember the nearer to 1:1 that you can get the lower the win loss ratio you will need to attain with your strategy to be profitable.
What About Rebates?
Contract rebates offered by some brokers simply help to cloud the picture rather than actually improve returns for the trader. Brokers that offer fixed rebates tend to offset this with a lower initial payout.
An example here would be the offer of a 15% rebate with a payout of 65%. This is actually a slow bleed strategy for your account as you lose out either way. If you win you fall drastically short of the optimal 1:1 win ratio and if you lose you only get a fraction of your investment back.
Given that the objective of most strategies is to build profits from ‘winning’, then you seriously jeopardize your account by trading with such an approach. You are simply handing your money to the broker.
It is important to consider the risk to reward ratio when trading with binary options as it is a fundamental trading concept that you should factor into your strategies. While for the most part you will you will be limited to what a broker is prepared to offer in terms of payout for ‘in the money’ contracts, it is nevertheless important to factor individual contract returns into your trading equation.
The best approach that you can take is to minimize your risk by looking to achieve consistently high levels of payout for each contract that you place. This may involve having accounts with several brokers and comparing the return offered on contracts to find the highest payout. This will help to put the odds in your favour and give you the greatest chance of profitable trading.