Binary options are also called digital options and as their name implies, have only two possible outcomes for each trade. A position can either expire in-the-money and you win that particular trade gaining as high as 80% returns or expire out-of-the-money and you lose the entire money invested on that particular trade.
If you are looking to understand the concept of risk to reward ratio as a beginner, it can be defined in simple terms as the potential return versus the probable loss for every single trade executed by you. For instance, a 1:2 risk to reward ratio means that if you succeed the trade you can earn double the amount of money when compared to the amount you may lose if your trade is unsuccessful.
The Growth of Binary Options Trading
Binary options trading is a relatively new investment method which has grown by leaps and bounds in the last few years due to its overwhelming returns and limited risk. In other trading methods like spread betting, futures contracts or spot forex trading which support leveraging, the risk/reward ratio can vary based on the potential returns, leverage factor and borrowed amount.In margin trading, the returns can be much higher but at the same time risks are also substantial and traders use techniques like stop-loss orders to limit their risk.Ideally, professional investors will advise you to look for investment options which offer a risk to reward ratio of 1:2.
The biggest advantage of binary options is the fixed risk/reward ratio which means you will know how much money you can earn or lose before placing the trade. The important reason for the popularity of binary options is the limited risk, which means you can never lose more than the amount you had invested in a particular trade. Also, you can make profits with binary options trading even if the market is bearish and your assets are having a downtrend by choosing “Put” option.
The payout percentage promised by your broker is important to determine the risk/reward ratio as it can vary between different brokers.Hence you should always choose a reliable and trusted who offers high payouts of at least 80% like anyoption UK. For example, let’s assume you invest £100 in a trade where you bet against GBP/USD currency pair and the payout offered by your broker is 70%. Then it means you will get £70 profit if you win that trade and lose £100 if your option expires out-of-the-money. In this case, the risk/reward ratio for that particular trade is 1/0.70.
The Win/Loss Ratio
Apart from risk to reward ratio, you should also understand the concept of win-loss ratio or success rate which refers to the chance of winning a particular trade. Success rate is usually calculated based on past performance and expressed in terms of percentage. In simple terms, it is calculated as the number of winning trades divided by the total number of trades taken over certain fixed time period. If your success rate is 60%, then it means you are expected to win 6 out of 10 trades you execute.
So as a binary options trader you should consider both your success rate and payout offered by your broker in order to determine the exact risk to reward ratio. Most of the binary options brokers try to attract traders by promising unrealistic payouts and quoting high returns in terms of percentage which highlight only the positive side of these options contracts.
But in reality, if a trader loses 50% of the trades he executes, then he will lose 100% of his investment in all these trades unless the broker offers any refunds for lost trades. Hence the potential risk is 100% of your investment while returns can range from 60% to 90% depending on the payout offered by your broker. To explain in simple terms, binary options don’t even guarantee a risk to reward ratio of 1:1. Some brokers may offer refunds up to 25% depending on the type of trade you execute. You should choose such a broker who offers guaranteed refunds for lost trades as well in order to improve your risk to reward ratio.
An Example In Action
Let’s take a simple example to understand the risk-to-reward ratio of binary options. Let’s consider your broker is offering a payout of 80% for every trade you win and your success rate is 50%. For simplicity, let’s assume that you are investing £100 in each trade and you are executing 100 trades in a month. So, you would have invested an overall amount of £10,000 in a month and you have lost 50% of the trades which means you have lost £5,000 from your capital. For every successful trade, you would have got £80 as a return which means you have won £4,000 (Assuming you won 50 trades out of 100, each offering a return of £80 = 50 * 80 dollars).
After consolidating both, you will be surprised to know that you have lost £5,000 from your investment capital of £10,000 and your returns for successful trades are only £4,000. So overall in this example, you have lost £1, 000 from your capital and you don’t have any positive returns. In reality, a success rate of 50% is even considered high in binary options trading as most traders are known to lose 80% of the time. Since the payouts are fixed, you can only focus on increasing your success ratio in order to maximise your returns.
It is important to understand the risk to reward ratio in any form of trading to come up effective trading strategies. You should consider all the factors including your success rate, trading strategies, payouts and rebates offered by your broker etc. to have a clear picture of the risk to reward ratio. Understanding risk/reward profile of binary options is very crucial in formulating your trading plan and to become a successful investor.