As we covered earlier, the two biggest negative emotions that a trader has to deal with are greed and fear. When it pertains to individual trades, these two negative emotions can cause the trader to make the following two detrimental mistakes.First, traders tend to cut their winners short and leave profit on the table. You may enter a trade, see it go in your favor, and be so fearful of losing that profit that you get out of your profitable trade earlier than you were supposed to. Second, traders tend to let their losers run.
This happens because traders basically are too greedy to realize losses. They hold on to their losing trades with the hope that the trade is going to come back into positive territory for them.Even if you cut your winners short and let your losers run by a few points, over a large enough sample of trades, these numbers will add up and eat into your profits or cause you to lose.
For this very reason, binary options are a great instrument to start trading to mitigate this problem. The nature of binary options prevents traders from letting their losers run or cutting their winners short. Let’s examine how this works.As we learned, with a binary option there are two specific payouts at expiration: $100 per contract if you are correct and $0 per contract if you are wrong.
If you choose to hold until expiration, there is no way that you can possibly let your losers run or cut your winners short.For example, let’s assume that you purchase a binary option and decide to stay in the trade until expiration. If you are correct on your trade and the price of the underlying ends up above the strike price, then you will win on your trade and receive revenue of $100 per contract.
This will give you a profit of $100 minus the option premium. If you are incorrect, you will receive nothing and lose the collateral that you put up, which is equal to the option’s premium.When selling a binary option, it’s the same scenario. If you hold until expiration and you are correct, and the price of the underlying ends up below the strike price, you will earn the premium of the option.
If you are wrong and the price of the underlying ends up above the strike price, you will lose your collateral, which is $100 minus the premium of the option.Especially when it comes to a discretionary trading strategy and beginning traders, this approach can be very effective. By waiting until expiration,you no longer have to worry about when to exit your trade regardless of whether it is winning or losing.
You simply wait until expiration to see what your outcome will be.For this reason, even if you are getting into a directional trade, you can use binary options instead of the underlying instrument and simply hold until expiration. This way, you are no longer worried about when to get out or if the price will move past your stop‐loss. Of course, if you are actually trading the underlying itself, there is a possibility that you can get more of a gain than the binary option can offer.
To mitigate this, you can control it with your position size. Let’s examine an example of howto do this.Using Position Size: Let’s assume that you want to make directional trades on the EUR/USD cross when the rate is 1.3520. You predict that the rate will go up by 20 pips to 1.3540. And you decide to set a stop at the big figure of 1.3500.Let’s say that you have $10,000 in your account and you are willing to risk 2 percent of your account or $200 on any one trade. When entering this trade, you would put up 10 mini forex contracts.
This is calculated by dividing the max loss of $200 by the max single lot loss if your trade gets stopped out—$20.Binary Options Scenario:Exhibit 14.16 is an option chain of EUR/USD binary options.Let’s assume that you can buy an out‐of‐the‐money binary option for $30 with a strike price of 1.3540. To find out how many contracts you can trade, you can divide your max possible loss of $200 by the option’s premium (which is the most that you can lose per contract).
Once you do this, you will discover that you can trade up to six contracts.Let’s examine what happens when you enter a binary options trade with this scenario. If you hold until expiration and you are incorrect, you will lose $180. However, if you are correct, you will receive revenue of $100 per contract. On six contracts that is equal to $600; once you subtract the $180 collateral from this number, you end up with a profit $420.
This is actually more than twice as much of a profit as you would receive by trading spot forex.So you may be asking yourself, what gives? I should just be trading binary options all the time. Well, here is the caveat. When trading binary options, if you are holding until expiration, the price has to reach your target by expiration.