You will learn about the following concepts
- Why do you need a trading strategy at all
- How to choose one
- When is a trading system deemed successful
- Why do you need alternatives
No matter what kind of financial instruments you are trading, there are two common requirements for becoming consistently profitable – a set of sound trading strategies and an excellent money management system. Each binary options asset family (currencies, commodities, stocks and stock indices) have unique peculiarities, thus most fundamental-based strategies for trading stocks, for example, will need to be adjusted in order to work well for trading other types of assets.
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Properly tested and successful trading strategies are crucial for surviving the financial markets intense competition. You are doomed to fail, if you adopt a trading style which is based on chaotic cross-betting (entering positions on many different assets without following a thoroughly-tested and proven trading system). Thus, systematic trading is the way to go.
Some traders prefer fundamental analysis as a primary prediction method for price movement, while others base their decision-making entirely on technical analysis. A good amount of traders use a combination of both, with fundamental factors being their main source of information, while applying technical analysis to pinpoint important support and resistance levels, as well as possible turning points.
Why do you need to use a solid trading strategy
Systematic trading is crucial for long-term success and here is why:
- Sticking to a trading strategy allows you to remain focused amid the huge inflow of news and economic data that can seriously impede your analysis process. Moreover, trading the news requires profound knowledge in the pricing characteristics of a certain asset or asset class (often in combination with technical analysis for setting the entry and exit points), which many novice traders lack. However, using a predetermined trading strategy based solely on price action will allow you to profit, disregarding the constantly incoming news.
- You will be able to measure, and thus improve your performance. Chaotic trading lacking a certain trading plan leaves no opportunity to assess your performance, because you will have no constant basis for comparison. Using a trading system for a prolonged period of time allows you to build up a statistical database that will help you gauge its performance and once the assessment is complete, you can begin working on improving it. By changing certain parameters and comparing the new results again to the historical data, you will be able to see whether the upgrade was successful or not.
- You will keep your emotions at bay. Emotions are tough to overcome, especially when it comes to losing your hard-earned money. Greed and fear can easily take control over a novice traders mind after a streak of good or bad trades. When greed kicks in, you will begin to bet too much money with each position, open more positions than usual and often double your bets when you see that your option is currently “in the money”.
Conversely, when fear sets in, the trader will avoid entering good positions and bet less money than he should, missing on a lot of possible profits. Thus, hanging on to a trading strategy will allow you to disregard volatility in your current performance, which will help you rule out emotions and focus on your long-term success.
- Overtrading is your enemy as well. Without a trading system with clearly defined entry and exit rules, a trader can easily slip into a frenzy of position opening. The bombardment of news, “advice” from professional traders, tips from friends, even the phase of the moon (yes, there are studies tying the Moons position relative to the Earth with cycles in asset movement, especially stocks), can cause a trader to initiate more trades than he/she can handle.
Choosing the right one
If you ask a bunch of traders which is the best strategy to follow, each person will most likely point out a different one. Not only that, but they will also split in groups about the type of analysis they use, and whether they are combining them. The truth is, there is no golden strategy, simply because the financial markets are rapidly changing. Unwritten rules which have been in force before, no longer work and if you want to keep riding the wave, you will need to evolve just like the market is.
Having cleared that out, we can point out several characteristics, which a reliable trading strategy should typically have.
- The most effective and profitable strategies are usually quite simple. Of course, professional traders do employ advanced trading techniques, but piling more and more rules cannot guarantee in any way the strategys reliability and robustness. Quite the opposite. A very complex trading strategy, which intertwines a great variety of rules for different market conditions, would be difficult to execute and profit from, especially by a novice trader.
- Each strategy requires thorough testing before being employed. Demo accounts are your friends. Every trader uses them no matter his experience, since they are a great way to test any new idea for free. We said earlier that different assets have different trading peculiarities, thus a strategy which works well for stocks might underperform when you use it to trade currencies. To find that out and tweak the system, you should best use a demo account.
- Trading strategies become obsolete. Trading strategies do not remain effective forever. This is something quite normal, given the pace of development of the financial markets. Thus, a trading strategys performance is bound to diminish at a certain point, which requires monitoring. Once the strategy begins to underperform, you can fine-tune it, or you can just abandon it in case it entirely stops working.
- All strategies are subject to drawdowns. Each trading strategy, no matter how successful, will fail at a certain percentage of time. If the one you have chosen has a success rate of 60%, then in four out of ten times your binary option will end up “out of the money”. And because losing positions are unavoidable, the only thing you can do is to digest the losses with as little emotions as possible and stick to your trading plan and money management system. After all, it is the overall success we are after, not the temporary one.
Types of winning strategies
Speaking of success, it is worth mentioning that there are three types of winning strategies:
- The strategy can generate more winning than losing positions, and the average win is greater than the average loss.
- The strategy can yield more losing positions than winning ones, but the average win exceeds the average loss so that the net result is on the positive side.
- The system can generate more winning than losing positions, and although the average loss exceeds the average win, the net result is on the positive side
Logically, the first option is the best possible but coming across one is quite difficult. The second type of strategies is hardly a good choice for trading binary options, because usually the potential loss exceeds the potential profit. Of course, there are higher-yielding binary options, but they also involve greater risk. And while commonly you lose 100% of your investment when the option is “out of the money”, most brokers offer an average of 70%-85% payout ratios on their options. Some companies also offer a refund on losing positions, but that usually comes in exchange for a lower payout ratio, with the win-loss ratio remaining overall in favor of the latter.
And since you will most likely not be able to find a strategy from the first type, the third option is the best choice for you. Because overall the average loss will always exceed the average gain, we will need a trading strategy, whose high rate of success offsets the profit-loss gap in such a way that the net result at the end of the day/week/month is profit. Thus, these strategies will need to yield a result on the positive side of the breakeven. Below you can see the formula for calculating the breakeven point:
Breakeven (0) = Winning % x Average Return – (1 – Winning %) x Average Loss.
Basically, this equation shows what kind of success rate you need in order to be at breakeven, provided you know what your average return and average loss are. Thus, you will need a trading strategy which yields a success rate higher than the one required for breakeven.
Using a combination of trading strategies
Diversification, not only of assets, but also of trading strategies is a key component of profitability. Traders usually use more than one trading strategy, since no trading system can cover the whole diversity of market conditions. Here are several reasons why you would want to rely on more than one trading system:
- Having more than one reliable trading strategy at your disposal well help you digest easier the inevitable losing stretch each technique will eventually produce. Once those losses begin to grind your confidence, switching to another sound trading strategy and, hopefully, reaping some profits will help you lift morale.
- As we said earlier, however, sometimes strategies simply stop working and become obsolete. This is the perfect time for switching to an alternative trading strategy, instead of attempting to mend the previous one and losing more money during the process.
- We have also pointed out earlier in our guide that asset diversification is a crucial hedge against drawdowns. If some asset or asset class defies your expectations, especially when you have purchased an option with longer maturity, having opened positions in other assets (or asset classes) may offset those losses, keeping you at or above breakeven. However, because different asset classes tend to have varying trading specifics, you will need different optimized trading strategies for each, which calls for a system of trading strategies.