In this chapter we are going to look at another hugely contentious issue which surrounds this market, and concerns the central trading tenet of risk and reward. But before we start let me restate.There is nothing wrong in trading using a fixed odds approach provided it is coupled with a sound analytical methodology such as volume price analysis. This will help shift the odds in your favor and away from the broker.
Bookmakers and bucket shop brokers have been around for many years and have survived for one simple reason. The odds are always in their favor not yours, and I hope by the end of this chapter you will understand why.My objective here is to explain the maths of odds, probabilities and returns, as they apply to the instruments we have considered thus far, namely off exchange and on exchange binary options.
As you will discover the 70% to 85% returns marketed by the bucket shop brokers are not as good as they would have you believe. This is one of the less desirable aspects of the binary market at present. It is awash with headline grabbing claims which, when considered logically are highly misleading. The same applies to sign up incentives. It’s just clever marketing. The maths explained here will reveal the truth behind these claims.
The Maths Of Break Even:Let’s begin by considering break-even from the traditional standpoint of a trader in a conventional market, before moving to consider how it applies to both off exchange and on exchange binary options.The generally accepted wisdom for growing a trading account longer term is premised on keeping losses small and profits large. Trading is not, and never has been, about the simple ratio of winners to losers.
It is about the relative size of those winners to losers.Many people outside the trading world believe it is a 50/50 business. It is not.When trading binaries it is very different. Here we are dealing with an instrument which is capped both to the downside and the upside. Our risk is capped which is great, but then so is our profit. This creates a unique profile and one which undermines the perceived wisdom of trading, which is premised on an entirely different risk and reward profile.
I have created two simple schematics in Fig 5.10 and Fig 5.11 to explain this principle graphically. Binary profile of risk and reward:In Fig 5.10 you can see the schematic representation of risk and reward. The risk is fixed and known, but so too is our reward.In the conventional world of trading, and assuming we are using a stop loss, the risk reward profile is represented in Fig 5.11. Here we have limited risk, but our profit potential is unlimited.
The profit line can continue higher for as long as we have the position open in the market. Our risk is still defined and capped at a maximum, but the profit potential is unlimited. It is this simple fact, that sets binary options apart from the more conventional approach to trading, and herein lies the central issue.As mentioned, long term success in trading is premised on keeping losses small and letting winners run.
In a sequence of ten trades, seven could be negative and three positive. However, provided the three positive trades are relatively large, and the seven negative trades small, overall the trading account balance will increase. This is how the maths of trading has always worked. The reason why many traders struggle to move forward is they allow losses to build and cut profits short. This has been confirmed to me by a number of brokers over the years.
Getting in is easy, it is staying in and then holding to maximize any profits which are the most difficult things to do. But, they are the foundation stone of success, and is why the maths of trading is often counterintuitive. If this ratio can be improved to four in ten or greater then so much the better.We do have to differentiate between on exchange and off exchange binary options.
In the binary options model, whilst the risk to reward profile is the same, there are two major differences. First, you have the ability to set your own entry and exit points in on exchange binary options. Second, this in turn allows you to define your own risk reward parameters for the mainstream products. But let’s just stay with the off exchange example.There are several issues here so let’s consider them one by one.
In the above scenario in conventional trading I suggested that three positive trades to seven negative trades could still produce positive results. In other words 3/10 or a 30% success rate. Reduce the number of negative trades to 6, and the ratio moves to 4/10 or 40%. Does this sound reasonable and achievable? Four correct and six incorrect, and the maths still works for us as our losers are small, and our winners outweigh these.