Anyone who has been trading binary options for any length of time knows that there are going to be peaks and valleys in your trading career. The peaks are great—these are the moments when you can’t seem to get a trade wrong and you are very profitable. The valleys can be downright depressing. The Draw Down concept is applicable to those times when you are headed toward a valley, and your focus is on survival more than hitting the optimum winning trade.
The Timing of Application
The drawdown strategy is all about money management and recovering losses. Let’s say you start out with $10,000 in trading capital, but lose $5,000 shortly after you start. Your draw down is equal to the percentage that you’ve lost, or 50%. This is important to keep in mind because the bigger your draw down, the more difficult it is to come back to where you once were. If you lose 50%, you now need 100% profits just to breakeven.
The first step to beating the draw down is to prevent it from happening. A gambler’s first reaction when losses start is to start upping the risk—and therefore the potential reward. However, great traders are never gamblers, and chasing losses is never the best choice. So, instead of doubling your risk with the hopes of doubling the profits, you should be backing off. Begin by easing down the risk, not escalating it. If you stick to a percentage method of money management, this is quite easy to do. With an account size of $10,000, risking 2% per trade is equal to $200 per trade. This is a completely acceptable number if you have a good edge on the trade. At $1,000 in your account, 2% is now equal to $20. This is a great trading amount if you have that same good edge described above. Your amount that you risk should be in proportion to the amount that you have in your account. So, when you find yourselves in the beginning stages of a potential draw down, keeping your risk proportionate to where it’s always been in terms of your edge will make it much harder for a draw down to occur. If you are an experienced trader and have seen success, you will never go broke if you stick to a trusted risk evaluation method, such as the half or quarter Kelly method.
Another method of handling this is to do what is called a reverse pyramid. When you are building wealth, you are adding to weak positions as they grow. In a reverse pyramid, you are doing the opposite. You have strong positions, and you are now backing off on them. In binary options, this means less frequent trading, smaller position sizes, and only trading when you are extremely confident in the outcome. This should be done when you first start to notice a decrease in profit rates in order to prevent the draw down from ever happening.
Not Always Fool Proof
The draw down is a tough concept to recognize if you are not experienced, and unfortunately, many people do not know what it is the first time that it occurs. This ends up leading to catastrophic losses. Seeing trends is easiest in retrospect, and the new trader doesn’t have the ability to do this. That means that the only way to be able to effectively stop catastrophic losses such as a draw down from occurring is to have been successful for a while, and have suffered losses in the past. In the end, if you haven’t made it to this point already, you probably won’t be able to stop a draw down, which has a lot of negative potential. New traders then, should be focusing on building experience more than building wealth by taking more conservative positions until more experience and confidence is gained.
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