One technique that is commonly utilized to limit the insidious effects of drawdowns is called the reverse pyramid strategy. What exactly is a drawdown and why must policies be implemented as a priority to minimize its impacts, if possible. This negative aspect of binary options trading occurs whenever you experience losses. The following diagram illustrates the basic concepts of a drawdown.
What are equity drawdowns?
For example, envisage that your account balance is displaying a peak value, as demonstrated in the above diagram. Imagine that you now suffer a loss causing your equity to crash to the point labeled by ‘tough’. The size of your account reduction is termed the ‘drawdown’ and its range is displayed above. One of your key objectives when trading binary options is to minimize, if not eliminate, the negative effects of drawdowns as a top priority.
Why is this policy so important? This is because drawdowns can easily wipe out your account balance if left unchecked. They are dangerous features of binary options trading because they possess a negative compounding factor that can seriously restrict your efforts at making profits consistently. The following table clearly identifies the dangers that drawdowns pose to the safety of your equity by presenting the draining nature of successive 10% losses on an initial account balance of $20,000.
|Account balance:||% Total Loss:||% Profit need to recoup original equity|
After analyzing the above table, you can verify that drawdowns harbor a powerful negative compounding factor that possesses the ability to devastate your account balance rapidly. In addition, you will observe that the profit percentage that you will require in order to regain your initial account balance increases exponentially following each successive failure. This feature implies that your objective to recoup your losses becomes progressively more difficult as your ‘out-of-the=money’ results mount up.
Now you can appreciate why professional traders make significant efforts as a top priority to reduce the negative impacts of drawdowns on their binary options activities. One tool they deploy to achieve this objective is the Reverse Pyramid Strategy. So, how precisely does this technique function?
Example of a reverse pyramid strategy
This binary options strategy necessitates the requirement for traders to diversify their risk exposure following either extensive bull or bear runs. For example, imagine that the price of an asset has risen recently within a well-defined bullish trend. In addition, assume that you have opened a CALL binary option at the start of the trend using a wagered amount of $10,000 and an expiry time of 1 month.
Envisage that after 2 weeks, you detect that price could be peaking after you identify a ‘double-top’ candlestick formation on your trading chart. The problem that now arises is that you do not know for sure how deep a correction that could occur if a full-blown price reversal is created. You can implement tools, such as the Fibonacci Retracements, to help you assess whether the price will just undergo a temporary retraction or if it will enter a new bearish trend.
As such, these uncertainties now place your account balance at risk of the impacts of a major drawdown. For instance, if the price plummets dramatically so that its final value at expiration is below its opening figure then you could suffer a serious loss. Alternatively, a minor retraction could simply occur before the price bounces back upwards in its original direction.
The major problem is that you could incur a significant drawdown resulting in a $10,000 reduction in your account balance. As previously stated, you must limit the impacts of such eventualities, whenever possible. Always remember that if you can control your losses then your profits will look after themselves. This is where the Reverse Pyramid Strategy comes to the fore as it offers a definite solution.
You can instigate such a strategy by not opening just one binary option by wagering $10,000. Instead, you must execute four trades constructed on the same asset using identical parameters, i.e. $2,500 wager and 1 month expiry time. By doing so you will then have the ability to implement a Risk Pyramid strategy after the price hits a peak and starts to retract.
The idea is that following a drop of 5%, you must then sell one of your CALL positions back to your broker. This action implies that you would have dramatically reduced your overall risk exposure by accepting a 5% loss at that point. You must then proceed to activate a similar procedure after three further 5% losses, creating a pyramid structure.
Should the worse scenario then occur and a retraction is created resulting in you initiating all four steps, then your maximum drawdown could be limited to 20% of your wagered $10,000 equaling $2,000. This is a great improvement over the standard procedure of opening one trade and losing the entire amount at expiration. In summary, by implementing a Risk Pyramid Strategy proficiently then you would have fulfilled your objective by significantly minimizing the insidious impacts of drawdowns.
However, to implement this powerful tool correctly, you may need to upgrade your standard account with your binary options broker. Essentially, you will need one that possesses a full ‘SELL’ functionality so that you have the ability to sell your positions back to your broker before expiration. You will find that many brokers do not service basic accounts providing you with such a feature. As you may be required to make much larger initial deposits in order to operate a Risk Pyramid strategy, you can subsequently appreciate why this advanced tool is not recommended for novices.
(Risk warning: Your capital can be at risk)