How to Manage Your Risk trading Binary Options
THE RISK IS YOU!
It is essential to manage risk. Most traders fail due to a lack of risk management. They either over-trade or do not work their plan and all of its elements. What is important to understand is that we comprise the only real risk in trading. We are our own risk. In the last analysis, we are the only ones who are responsible for our results. When you trade, you are trading yourself. We will only get out of our trading what we put in. If we blame the market, we should really blame ourselves, instead. There is no one else to blame.
How we trade is what we are. Trading is only a mirror of our strengths and weaknesses, as will be our results. This is why, in order to really control our risk, we should begin with ourselves.
What we should understand first are our weak points, relative to trading. There are many flaws in our individual behavior that can immediately bring catastrophic results to our trading. We are not speaking here of trading psychology, but of tangible and specific trading procedures. For example, do we keep records of our trades? Many people do not. Persons who do not keep records do not test anything or have any coherent trading knowledge. In the long run, they always fail. Do we know our risk/reward ratio? Do we know our win/loss ratio? If we do not, it is better if we do not trade.
In summary, do we know today what we should be doing as traders and are not doing? Those are our real weaknesses. Let us examine them.
When we trade, we must study the market, our trading system, our position allocation, our asset allocation, where to place our stops, etc. We should also know everything about our system before and after testing it. Accomplishing all of this in an orderly way is being organized in matters that concern our trading.
We will have built an organic system that will enable us to trade efficiently. If we are not organized, we will never achieve a coherent trading strategy and practice. This is easy. Go slowly at first and take simple steps.
Are we logical? This is another aspect of the trader’s mind. We need to understand the relationships between the different elements that we must incorporate in our trading. We must know not only what to do but also why we should do it. A contrary example is provided by traders who buy systems that they apply without really understanding them.
The same can be said of a trader who excludes important elements from his trading arsenal. For example, if a trader excludes risk/reward ratios or asset allocation or position sizing, it is basically because his thinking is faulty. He does not understand
what he does or why. We may forgive this trader for his ignorance, but the market will not.
It is important to have the ability to get to the core of a system, to its key element that ties the rest of it together, and to learn how and why it does. To be able to synthesize information is important for trading.
Do we tend to think before we act? Alas, this is not the case with most traders. They trade on a whim, without planning or following a system or understanding it. All trading should be based on very careful reflection and thought. All elements and scenarios should be considered before we trade.
How is our trading life curve? Every trader has a life curve. It can be ascending, flat, or downwards. The important thing here is not what you do or what you have done. Instead, the only thing that matters here is whether you have an ascending learning curve – whether you are expanding your trading knowledge and trading practice.
If you read about trading, study the markets, and practice and learn from your mistakes, you are heading down the right path. This is not true of most traders. Many traders do not want to learn about the markets. As a result, they repeat the same mistakes – year after year, over and over again – for a lifetime. It is essential to break this pattern.
The elements that we have considered can be riskier for our trading than the worst of market conditions. All of our trading results mirror our trading qualities.
Here, we should add a word about Sokyu Honma. He certainly was not like everybody else. He was a special person, which is why he became an excellent trader. If he was honored as a samurai by the Emperor of Japan, it was because he really was one. A samurai is responsible for himself. He has the courage and the strength of character to discipline himself. Sokyu Honma was a very special person because he did all that was necessary to become one. His qualities made him a great trader.
It is because of the qualities that trading demands from us that we should develop, and to which, above all, we should be attentive. If we are, we will reduce and control our risk, and excellent trading will naturally follow. Let us now look at risk in relation to markets and trading systems.
THE ELEMENTS OF RISK
There are many types of risk in trading. It is important to be aware of them. We will consider market risk, vehicle risk, and money management risk. Firstly, let us discuss market risk. By market risk, we mean the risk of the market, as a whole, collapsing. For example, this is what happened in 1929, 1987, and 2001. This kind of risk will affect all of our positions. If we had been in the stock market on those dates, we would almost certainly have been hit. The point here is that this kind of risk cannot always be avoided. It can just happen, and it cannot be forecasted. This is true for the simple reason that forecasts do not always work.
Let me explain. When market risk comes into play, forecasts are irrelevant. The reason is that we cannot always correctly forecast a market catastrophe. Even if we could, we should integrate the fact that it can, and will, happen to us.
In the same way that some analysts correctly forecasted the major market crashes, many did not. Trading systems should never depend on always being right. Market risk is a reality that should be acknowledged. It should be integrated into our system. This happens automatically when we do not over-trade.
If our asset allocation, position allocation, stops, and all other elements of our system are well formulated and in place, nothing too bad should happen. If a market catastrophe does occur, we will simply have a loss that our system has already accounted for. In the long run, a well-devised system should be a winner overall in its trades. In brief, such a system will account for market risk.
Vehicle risk is our next kind of risk. This is the risk of losing because our chosen trading instrument does not work. In this case, the stock or commodity that we bought or sold did not work as we thought it would. Again, our system will take care of this. If our system has a reasonable risk/reward ratio and win/loss ratio combined, we will have a winning system, even though we will have some losing trades. If all the elements of a trading system are in place, we have nothing to fear.
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Our next item is system risk. This is the risk that, at a given moment, our system will stop working for a lengthy period or even indefinitely. This can happen to any system. This risk, also, must be accounted for beforehand.
Asset allocation and position allocation, as well as stop placement, will enable us to have our system fail without bringing ruin. Our working capital will still be there, if the worst does happen. However, this should not happen to a sound system that is based on fundamental market structure and principles. It happens mainly with statistically based systems that do not have solid market structure foundations.
Then there is money management risk. This is simply the risk of not having a sound money management structure, of having incomplete or bad money management, or of not following our money management rules, even if they are sound.
After dealing with these risks, we must account for the risk of lack of knowledge, of not having an adequate market knowledge base. An ignorance of market behavior can be fatal.
THE RISK OF NOT UNDERSTANDING MARKET BEHAVIOR
Market knowledge is fundamental. Studying technical analysis is a must. Modern and classical analysis should be studied. Also, a great deal of practice is required until we can feel the market. We need a feeling based on knowledge, study, hard work, and practice. We do not need the kind of irrational, impulsive feeling that many people have.
Here are a few mistakes that we can mention:
1. Bad timing comes either from inadequate market analysis or from limitations in the sensitivity of the indicators used. Our signals can be too early or too late, or simply wrong.
2. Choosing the wrong vehicle is another common mistake, such as buying without having studied a large sample of possible trading vehicles. Vehicle selection is choosing the right stock, commodity, etc. As already mentioned, the selection can be more important than our entry. It is important to always trade the most active markets and choose the vehicles that are on the move and favored by general conditions.
3. As we have already seen, not knowing how to diversify correctly entails a risk that can be easily avoided. Correct diversification comes from market knowledge. We should be able to select the best stocks to trade within a large enough sample.
4. Not knowing how to scale our trades also entails risk and comes from a lack of market knowledge and study. To allocate our positions, we must first define a scale or interval at which to add our new positions.
5. Untimely exits also imply risk that comes from not having sound market knowledge and experience. We may sacrifice profits or even ruin our system by an untimely exit. If possible, we should find ways to stay in a trade as long as it is profitable.
I have shown you a sample of risks that result primarily from a lack of market knowledge. In order to avoid them, we must read, study, and practice until we have theoretical and practical knowledge of trading and markets.