Binary options are an all-or-nothing option type where you risk a certain amount of capital, and you lose it or make a fixed return based on whether the price of the underlying asset is above or below (depending on which you pick) a specific price at a specific time. If you are right, you receive the prescribed payout. If you are wrong, the capital you wagered is lost.
That definition has expanded though. Back in 2009, the US-based Nadex exchange created options that allow traders to buy or sell an option at any time up until expiry. This creates a wide range of scenarios, as a trader can exit for less than the full loss or full profit.
No matter which binary options you trade—Nadex options or traditional binary options—"position size" is important. Your position size is how much you risk on a single trade. How much you risk shouldn't be random, nor based on how convinced you are a specific trade will work out in your favor. View position size as a formula, and use it for every trade.
How Much to Risk on Each Binary Options Trade
How much you risk on a binary option trade should be a small percentage of your overall trading capital. How much you want to risk is up to you, but risking more 5% of your capital isn't recommended. Professional traders typically risk 1% or less of their capital.
If you have a $1000 account, keep risk to $10 or $20 (1% or 2%) per binary options trade. Risk 5% ($50 in this case) is the absolute maximum and isn't recommended. When you start trading you'll want to make as much money as you can, as quickly as you can. Making some quick cash is why many people attempt trading. Avoid this impulse though. Risking a lot on each trade is more likely to empty your trading account than create a windfall. Most new traders don't have a trading method they tested and practiced, and therefore have no idea if they are a good trader or not. Better to risk small amounts of capital on each binary options trade, to test your trading methods and hone your skill, and then gradually increase the amount you risk to 2% once consistent.
How to Determine Risk on a Trade
Binary options have a maximum fixed risk. This lets you know in advance how much you could lose if the asset (called the "underlying," which the binary option is based on) doesn't do what you expect. For binary options, the risk is the amount you wager on each trade.
If wager $10 on a binary option trade, your maximum loss is $10. Some brokers offer a rebate on losing trades; 10% for example. If this is the case, your maximum is only $9, calculated as:
maximum loss + rebate = trade risk
-$10 + ($10 x 10%) = -$10 + $1 = -$9
Nadex binary options don't have rebates on losing trades, but if you buy an option at 50, and it drops to 30, you can sell it for a partial loss, instead of waiting for it to drop to 0 (or move above 50, which would produce a profit). Ultimately though, at expiry, the Nadex option will be worth 100 or 0. Therefore, when determining your risk you must assume the worst case scenario.
Nadex binary options trade between 100 and 0. With each digit representing a $1 profit or loss. If you buy one option at 30 and it drops to 0, you have lost $30. If you sell one option at 50 and it goes to 100, you have lost $50. You can trade multiple contracts to increase the amount you make or lose. This is a tutorial on position size, not Nadex options.
Determining Position Size on a Binary Trade
You know how much you are will risking risk (percentage of account, converted to a dollar amount) and you know how much money you could lose in a binary options trade. Now, tie the two together to calculate the exact amount of money you can wager on a trade.
If you have a $3500 account, and you're risking 2% per trade, the maximum you want to lose is $70. If the broker offers no rebate on losing trades (this is the norm), then only risk up to $70 on the trade.
In the "Amount" box on the binary options trading platform, input $70 (in this case). That means you are willing to risk $70 on the trade.
If the broker offers a rebate, for example, 10%, then you can increase your position size by the amount of the rebate...in this case 10%. Because of the rebate, you can risk $77 on a trade ($70 plus 10%). If you lose you will receive a $7 rebate, so your maximum loss is still only $70, which is in line with your 2% risk parameter.
For Nadex binary options you have an extra step because you can purchase an option at any price between 0 and 100, which affects how much you could lose. Assume you have a $5500 account and are willing to risk 2% per trade. That means you can lose up to $110 per trade and still be within your risk parameter. Don't take a trade where you could lose more than $110.
Assume you want to trade a gold binary options contract, because you believe the price of gold will rise today. You can buy the option at 50. If you are right, and gold is higher than the strike price (price level of gold that determines if you are right or wrong) when the option expires, the option will be valued at 100. You make a $50 profit on each contract you buy. If gold is below the strike price when the option expires, its value is 0, and you lose $50 on each contract.
Therefore, your risk is $50 for each contract you trade. You are allowed to lose up to $110 per trade, so you can buy two contracts at $50. If you lose on the trade you will lose 2 x $50 = $100. This is below the $110 allowed. You can't buy three contracts though because that exposes you to a $150 loss. A $150 loss is more than your established risk tolerance.
Considerations for Real World Trading
When you're starting out, calculate your ideal position size for each trade. Even when actively day trading there is time before each trade to quickly determine how much to wager based on your percentage risk tolerance and the trade you are considering. This repetition will serve you well, and when you are losing money the dollar amount you can risk will drop (as the account value drops) and when you are winning the dollar amount you can risk will increase (as the account value increases). Note that your percentage at risk doesn't change, but as your account value fluctuates the dollar amount that percentage represents does change.
As your account stabilizes you may trade the same amount on every trade, regardless of the fluctuations in your account. For example, the balance in my trading accounts stays the same. I withdraw profits at the end of each month, and any drops in the balance are usually quickly remedied by a few winning trades. Therefore, there isn't the need to make tiny changes to my position size on every trade. If your account value stays around $5000 (because of profit withdrawals, or profits and losses balance each other out), and you risk 2% per trade, then risk $100 per trade. Don't reduce or increase this amount by a few dollars every time your account fluctuates slightly above or below $5000.
The point of only risking 1% or 2% of the account is that you can lose 100 or 50 trades in a row before you are cleaned out. That's a good level of safety...if you are using a researched, tested and practiced strategy.
Not constantly changing your position size for every minor fluctuation in account value also allows you to make quick trading decisions in fast moving market conditions. If you know you can risk $100 on a trade, you can just act, instead of calculating if you can actually risk $105 or only $95. In the long-run, it won't matter too much.
Once you are creating a good income for yourself, and you are happy with your account size (withdrawing profits over that amount) then it is quite likely you will trade the same position all the time, and it will rarely change.
Final Word on Risk in Binary Options Trading
First, establish the percentage of your trading capital you are willing to risk on a single trade. Ideally, this should be 1% or 2%, with the absolute maximum being 5% (not recommended). For a normal binary options trade, this dollar amount gives you your maximum position size. For a Nadex option, also consider your maximum risk on the trade, and then calculate how many contracts you can take to stay within your risk limit.
In the beginning, calculate your position size on every trade. It's a good skill to have. As your account balance stabilizes—as you improve as a trader—you may opt to use the same position size all the time, regardless of the minor fluctuations in account value from day to day.