Trading options is significantly different from trading stock shares, mainly because the concept of risk does not work in the same manner in both scenarios. If in the case of stock trading on the currency exchange market one can easily use the conventional risk calculation algorithm, the same system does not apply to binary trading. Furthermore, leverage should also be considered in a distinctive manner when purchasing spot options, as the value of your investment and its potential loss/gain ration is considerably altered by the risk. Determining the appropriate amount of money that you can use when performing binary trading is crucial to your overall success. This will enable you to estimate the amount of leverage that you can use for each trade, as well as the value that it holds for you in light of the inherent risk.
The (ever changing) concept of leverage
The fact that a sum of money – say $10,000 – can vary in value depending on the type of trading that you do is the cause for most headaches in traders. Simply put, these funds allow brokers a certain ownership over their financial assets that differs from binary options to regular stock trading. Commonly, traders perceive leverage as an amount of money that is used to seize a larger position. Think of it in terms of futures contracts, where you can use $1,000 to purchase a contract that’s worth $232,000.
However, since the value of your money fluctuates depending on what type of trading you perform, financial experts have come up with a more ingenious theory about leverage. Successful traders incorporate a definition of leverage that simply equates it to the amount of money that is used to maintain a position (instead of gaining a bigger one), but using less finances to do so. Let’s take a look at an example to cut through the fog.
You have $100,000 that you can either invest in the stock market or use to purchase binary options. If you would purchase shares worth of $100,000 at $50 a share, that would give you 2,000 shares. In order for you to loose all of your money, those 2,000 would have to plummet to $0. Moreover, this would have to happen so fast that you would not be able to react and sell your shares at a lower price, thereby rescuing 80%, 50% or even 20% of your investment. Not only that the stock needs to take a dive, but it would also have to happen so fast that you would not be allowed to react. Such situations are almost unaccounted for.
On the other hand, if you would use the same $100,000 to acquire call options at $100 a contract and saying that those shares will trade at $52 tomorrow evening, that would give you 1,000 contracts. The same amount of money is spent, but if the strike price tomorrow evening is $51.5, you lose $100,000, whereas trading the same funds in the stock market will yield you considerably less risk.
Conventional and/or alternative risk calculation
The alternative way to calculate risk is to take into consideration the situation mentioned above. Basically, you stand to lose much more from a binary option purchase than you would with a stock purchase of the same amount. The same holds true for your gains, as they can be considerably larger with spot contracts. This happens because of leverage. Consequently, a sound way to calculate the amount of money that you should spend on binary options is to project a calculus that takes into account the relative risk of stock trading.
Going back to our example, you are ready to put $100,000 in those $50 shares of MeatCorp. Seeing as you are a trader with experience, you incur a stop-loss mechanism that makes your brokerage account instantly sell the shares if they lose more than 20% of their value. This means that when the strike price of the shares is $40, you will release them back on the stock market, losing $20,000, but still saving $80,000 in cash. This means that you are ready to risk those $20,000 in order to gain more finaces.
If we are to translate this in terms of binary options, it is those $20,000 that you should use out of your $100,000 in order to perform spot trading. Supposed that you are really fond of MeatCorp and believe their worth will increase to $55 per share. What you can do is use those $20,000 to purchase binary options. In the case of call options, you would also have to say when this is going to take place. You’ve decided this will happen on September 21st, your birthday. When performing trades on binary options that you can settle, the sound way to do this is by making the difference per share, which is $5 in our case and then settling a number of shaes that you are willing to buy should your prediction comes true. For 2,000 shares, your contract would have to be at least $10,000 ($5×2,000 shares), which is less than our risk margin.
It may happen that MeatCorp’s shares are worth $60 at that date, time at which you have the option to buy 2,000 for $55, thereby instantly making $10,000 in profit, with the same amount invested. That is 100% profit. Most brokerages offer various compensations for each spot contract, so you will have to make this calculus every time you consider trading on a particular brokerage platform.
The key difference lies with risk calculus and management. It’s highly uncommon for a share price to drop to $0 from $50, but it’s very likely that it will go to $40, sooner or later. If this happens, you’ll loose $20,000 right off the bat. There’s no telling what can happen later on, so it would be best to sell now. However, with binary trading, you already know that the most you can lose is no more, no less than those $10,000 you’ve spent on the contract.
You may also realize on September 15th that your prediction won’t come true and MeatCorp will sit at $53. In this event, it’s possible to sell your binary contract on the exchange market and instead of wasting all of your $10,000, you’ll gain back $4,000 ($2, the difference between your prediction and the strike price now, x 2,000, the number of shares).
The concepts of risk and leverage may vary substantially from the stock market exchange to spot trading. For this reason, it is imperative that you re-evaluate your risk when switching from one system to another and correctly assess the power of your leverage in order to make it work in your favor