Directional Trading using Nadex Spreads

In this lesson:
  • The built-in risk control of Nadex spreads
  • The difference between the spread’s linear correlation and the binary options all-or-nothing final result
  • Reasons to choose wider or narrower ranges and longer or shorter time frames

Both Nadex binary options and spreads limit your maximum risk to the initial trade cost. However they have different profit potentials, they move differently, and let you use different strategies.

When you trade market direction using futures or forex, you have unlimited profit potential. However, because futures and forex involve leverage, they also carry substantial risk. You can use stop-loss orders to gain some protection against adverse moves, but this also means you can get stopped out of the trade, only to watch the market turn back in your direction without you.

Nadex spreads are based on those same futures or forex markets, but they don’t have the same leveraged risk. With spreads, your risk is limited and your profit potential is also capped. This built-in risk limitation—without the risk of being stopped out of the trade—protects you from catastrophic surprise movements. The price of the spread can never go outside the predefined range.

Nadex spreads let you buy time to stay in your position without the worry of being stopped out. Your spread can only lose as much as you were prepared for, and no more, no matter how far the underlying market moves.

Nadex spreads have a short duration, which means that you get a final result in a short time, with less upfront cost. You don’t pay a premium for time that you aren’t going to use. This keeps the cost of the spread lower than it would be if it had a duration of weeks or months.

The spread is designed to follow the movement of the underlying market. While the spread price reaches its minimum or maximum as it approaches the floor and ceiling of the range, in the middle of the range the spread pricing closely tracks the underlying.

Nadex Overlapping Spreads

Example: trade the S&P 500 index with a Nadex spread

Let’s look at an example of using the Nadex US 500 spread, which is based on the CME® E-mini S&P 500 Index® Futures. The trading process starts with you forming an opinion on the market’s direction, setting a target price and an expected time frame for the move.

If you are looking for a larger move in the market then you would likely want to use a spread with a wider range. If you’re looking for a smaller move in a shorter time frame, then the 2-hour spreads with a narrower range could be a better fit.

Let’s say in the morning you see the E-mini S&P futures trading at 1961.50 and you expect it to trade up to 1983.00 by the end of the day (4:15pm ET). At the same time, you see the Nadex US500 spread 1955.00 -1985.00 is priced at 1962.50. This spread range contains the entry and target prices you want to trade and has a time duration equal to the time you want to be in the trade. So the terms of engagement are the same, but the cost is much different.

If you bought the spread at this level your initial cost is the difference between the trade price and the floor of the spread at 1955.00 (1962.50 - 1955.00) or $75/contract. The spread is divided into increments of $1 per tick.

If the market trades lower, your maximum risk is that $75 per contract, no more, even if it drops 100 or 200 points. Your upside profit potential is $225 (1985.00 – 1962.50). Your target price of 1983.00 has a potential profit of $205(1983.00 – 1962.50).

The total value of the spread is $75 plus $225 or $300, the sum of what the buyer and seller put up. By buying at 1962.30 instead of at the underlying futures price of 1961.50, you are giving up an 8-tick edge. The seller, meanwhile, is gaining an 8-tick advantage. That’s why the seller pays more ($225): they accept a greater maximum potential loss in exchange for that advantage.

The buyer gives up a slight edge, since the underlying market is still below the entry level of 1962.50. But the buyer has the possibility of a much larger profit ($225) if and when the market goes up and takes on a lower risk, because the buyer's maximum potential loss is only $75.

Nadex Overlapping Spreads with Different Durations

Smaller moves in a shorter time frame

If you’re looking to capitalize on smaller market moves within shorter time frames, the Nadex spreads with 2-hour durations and narrower ranges may be a better choice.

Let’s look at another example using the US 500 2-hour spreads. This time the spread range is 10 points with a value of $100. If you buy or sell when the underlying is in the middle of the range, you’ll pay around $50 and so will the trader or market maker on the other side. That 50/50 splitting of the cost reflects the fact that neither side has a significant edge over the other.

Or to put it another way, since neither side gets an edge, neither side has to pay a premium. Instead, they both pay the same amount for the same odds of success.

The high correlation of the Nadex spread with its underlying market is one of its key benefits. Within its range, the spread moves in a linear correlation with its underlying market. Binary options, by contrast, are priced based on buyer and seller demand. While binary options have an all-or-nothing result at expiration, spreads expire at the price of the underlying if it’s within the range, or at the floor or ceiling if the underlying is outside the range.

Because the range is narrow, you can set a clear, reasonable target and exit strategy. And because movement is closely correlated to the underlying indicative market, you don’t have to wait for expiration to capitalize on the move. Finally, the narrower range means your upfront cost is smaller—you only pay the premium for the time and risk you want to be exposed to.

 

At this point you should understand:
  • How spreads limit your risk without stopping you out of the trade
  • What linear correlation means
  • How to choose a price range and expiration

 

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