Binary options are unique options products that allow investors an opportunity to earn returns based on movements in the market that can be considered short term in nature. Most trading strategies are designed to capture returns based on a directional moves in the investors favor. The return is calculated based on the degree of that movement. Binary options are based on a “all or nothing” concept, where an investor is paid based on a movement in their favor regardless of the size of the change in price.
The “all or nothing” concept favors trading strategies that win more than they lose despite the size of the loss. Most analysts that back-test trading strategies are looking for specific criteria that allow them to feel confident in the results, as well as, show robust historical profits. In general, conventional analysts are looking for a strategies in which there are more winners than losers, but more importantly a solid profit factor.
The profit factor examines the win to loss ratio, and combines this with the amount won in each trade compared to what is lost. This calculation creates a numerator where the average of the number of wins in the time series, multiplied by the average amount won, and the denominator is the average of the number of losses multiplied by the average loss. A profit factor of 1 means that for every dollar speculated, an investor should expect a dollar returned.
Investors that are looking to speculate using the binary options markets, do not need to concern themselves with a profit factor or the amount won or lost when back testing a system. Since the payout profile of binary options is the same despite the amount won or lost on a trade, only the winning or losing percentage is relevant.
For example, let’s examine two specific trading strategies. The first strategy is a breakout systematic strategy that shows historical results where there are 100 trades. This strategy has 65 winners and 35 losing trades. The average amount gained on each winning trade is 1%, and the average amount lost on each losing trade is 4%.
A second strategy is also a breakout systematic strategy were the historical results show 45% winning trades and 55% losing trades. On each winning trade, the results are 5%, and on each losing trade the loss averages 2%.
In the above two strategies, conventional analysis would conclude that the first is worthless while the second was concrete. On the other hand, using the first strategy for binary options trading is likely to produce a significant winning strategy as the profits are fixed, and the amount won on a trade is generally close to or equal to the amount lost.
Analysts that are evaluating a binary options trading system should examine the percent or winners to losers to see if the system produces a signal that is relevant despite the amount won or lost on a given trade. Traders who want to design a system to trade binary options, should consider back testing systems that are geared to this type of performance.
Many of the current binary options brokers have a payout profile that is close to 83 cents for every dollar used to speculate on a trade. They create this outcome by paying 70%, and returning 15% on every dollar wagered. 70/85 = 83%.
To calculate a binary options strategy that will produce profits, an analyst will need to use the payout profile to determine the potential winning percentage. For example, 83% payout (83/100) is equivalent to 45% losing to 55% winning (45/55). This means that an binary options trader will need to win 55% of the time with a payout of 83% to have a winning strategy. On 100 trades, a 55 * 83 = 4565, where 45 * 100 = 4500. The total profit of $4565 is greater than the loss of $4500.
Binary options trading is designed to use leverage and a payout style where the number of winning trades outnumbers the number of losing trades. This works very well with breakout strategies, and sharp mean reverting strategies, but might be less effected with long term trend following strategies. The unique payout of binary options makes conventional strategies less effective, and creates the need to find strategies that fit the payout profile produce in the binary options market.