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So how does understanding probabilities help when devising a strategy for trading binary options? Well, in some respects a binary option resembles that flip of the coin. The outcome is that you win or you lose; your prediction either pans out or it doesn’t; heads or tails.

Only it’s not quite like that, primarily because the financial risk/reward aspect isn’t evenly weighted (and neither in all likelihood is the probability of the outcome).

This shouldn’t surprise anyone; after all, it’s well known for example that casinos fix a 5% advantage over their punters. With a typical binary option you can reasonably expect your stake back plus an 80% gain for winning and a 100% loss for, well, losing.

The implication of course is that in order just to break even you need to average 5 correct predictions for every 4 incorrect (assuming you’re not into totally idiotic “trading strategies” such as accumulators, where all you’re doing is playing Russian Roulette with an ever mounting pile of money to instantly blow away).

The “house” (in our case the broker) has a clear built-in advantage. So if, for example, you place a series of $100 trades and the first 4 lose then obviously you’re down by $400. But say you then start winning and pocket $80 “profit” each time. Obviously, after 5 wins you’ve recovered your $400 and are back to where you started.

So to end up all square you have to somehow counter the 5:4 mathematical advantage of the house with one of your own. Anyone placing essentially random bets will lose their money and most likely rather quickly.

Dealing with the Known Unknowns

The thing is though, it is possible to identify potential trades where the probability of a particular outcome offsets the payout ratio that is biased to favor the house.

Correction: it’s possible for anyone prepared to put in the research, if not for the legions of dumb asses who think it is somehow easy to just start making money using binary options with no prior expertise or experience.

In such cases, the math is on your side for once and among the best known equations for sorting the wheat from the chaff is the Kelly Criterion.

As the introduction in the previous link makes clear “The central problem for gamblers is to find positive expectation bets. But the gambler also needs to know how to manage his money, i.e. how much to bet.” This by the way was written by Edward Thorp whose reputation as a mathematician, gambler and investor strongly suggests he probably knows what he is talking about. He was also a good friend of the eponymous John Kelly (physicist, daredevil and all round interesting character)…

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