- The potential outcomes of a Touch Bracket trade
In the previous modules, we learned a Nadex Touch Bracket is a contract which allows traders to speculate on a market’s price movement within a pre-defined range and this range is capped on either end by the floor and the ceiling. We have also learned how this structure translates into the risk/reward profile of a Touch Bracket and how that in turn translates into the capital requirements to trade a Touch Bracket. In this module, we will pull it all together by walking through a trade example and looking at potential outcomes.
As we know, at the beginning of each week, Nadex will list 4 Touch Brackets with unique ranges on each market. These contracts have a maximum duration of 1 week. There are two important aspects to how these brackets are structured. The first is that the range is determined by historical market movement and is specific to each market. The next is that they are offset in such a manner as to provide at least one contract with a floor close to the indicative index and at least one other contract with a ceiling close to the indicative index. The goal of this structure is to provide both buyers and sellers an opportunity to place a trade with a very generous risk to reward ratio.
Let’s start with our previous example of the US 500 which has an opening level of 2720.00.
At the beginning of the week 4 brackets will be listed each with a unique range. If drawn on a chart, this would look very similar to the picture below. The dark blue line represents the level of the indicative index for the US 500.
As we can see, we have several choices. If we thought the market was going to move lower and thus wanted to sell a contract, the choice that would provide the least amount of risk, to the greatest potential reward would be bracket #4 on the far right. The reason, this bracket has a ceiling, which caps the risk of sellers, closest to the indicative underlying market.
If we thought the market was going up, we would want to buy a contract. The bracket in this scenario, that provides the least amount of risk and the greatest potential upside would be bracket #1 on the far left. The reason again, this bracket has the floor, that caps the risk for the buyers closest to the indicative underlying market.
Let’s walk through some scenarios
For this, we will discard the other brackets and focus solely on Bracket #1.
This image should look familiar from the last module. As we already know, if we buy this contract at 2720.00, our maximum risk is the floor of 2710.00 ($100.00) and our maximum potential profit target is the ceiling at 2760.00 ($400.00). The capital we post to secure this trade is equal to the maximum risk and is $100.00.
Let’s cover the worst case scenario first. By the way, one of the greatest benefits of a Touch Bracket is that you can clearly define a worst case scenario before placing the trade. Traders working in leveraged products don’t have that luxury and can often find out too late how hazardous this can be.
So, worst case scenario: The market drops to 2710.00 or lower. If this happens, the trade resulted in a $100.00 loss, plus exchange fees. By the way, even if the market gaps down 10’s or hundreds of points, we can never lose more than what our initial risk was on the trade.
Best case scenario: The market climbs higher and our contract hits the ceiling of 2760.00, immediately expiring at that level for a gain of $400.00, less exchange fees.
Another scenario: The week goes by and the contract never touched the floor or the ceiling. In this case, on Friday, the contract expires and is considered a variable payout contract. The final settlement value for this contract will be determined by the settlement calculation referenced by the Nadex Indicative Underlying Index and any profit or loss will be determined by the difference between where the contract was bought or sold, and the final settlement price.
In this example, the market climbed higher and at expiration on Friday, settled at a value level of 2750.00. In this scenario, the original buy level was 2720.00 and the settlement level was 2750.00 or 30 points higher than where we bought. In this scenario, the profit would be $300.00 per contract, less exchange fees.
Of course, should we have chosen to, we could have closed out the position prior to expiration to lock in profit.
Trading a Touch Bracket is really straightforward.