Risk/Reward Profiles

In this lesson:
  • The floor-to-ceiling price range of Nadex spreads
  • How spread risk and reward are calculated using a simple difference in prices
  • The variable price settlement of Nadex spreads

You never know where the market will go next. It’s a tough truth of trading to accept. That’s why risk management is the first and most important skill for a trader to master. Successful traders will tell you it’s even more important than predicting market direction.

Nadex spreads are designed for this time-tested, perhaps more mature approach to trading. Your risk is limited by the very design of the spread. And the floor and ceiling structure gives you a natural profit target and exit strategy. In baseball terms, think of it as going for base hits, consistently, rather than swinging for the fences repeatedly and increasing your odds of striking out.

Spreads let you trade the long and short side with equal ease. If you are a buyer, the floor defines your risk: the most you can lose is your entry price minus the floor price. If you are a short seller, your maximum loss is the difference between your sell price and the ceiling. You can trade a price range with precisely defined risk, guaranteed. That’s more than you get with a conventional stop-loss order.

Since the spread value can never go higher than the ceiling or lower than the floor, that also means that your reward is capped. True, this means you give up the “unlimited profit potential” some people talk about. But in exchange, you get a natural profit target and a way to plan your trade from entry to exit.

Risk

You know your maximum possible risk before you enter your trade. Your order ticket will show it to you before you hit the Place Order button. You can never lose more than that maximum amount.

You will buy or sell at a price between the floor and ceiling. Let’s say you’re a buyer of this euro spread contract:

EUR/USD 1.0720 – 1.1320 (3PM) (26-FEB-16)

That’s a spread on the spot euro – US dollar exchange rate, expiring at 3PM on the 26th of February.

The floor price is 1.0720. The spread price can’t go below 1.0720 no matter how far down the underlying indicative market falls.

The ceiling price is 1.1320. The spread price can’t go above 1.1320 no matter how far up the underlying indicative market rises.

The spread’s price will fluctuate between these two prices. Let’s say you bought at $1.0930 to the euro.

Your order ticket shows that your maximum risk, your maximum possible loss, would be $210. Add $1.80 for fees and that is the most money you could lose.

 

Reward

Since all Nadex contracts are fully collateralized, the buyer and seller together put up the full value of the spread in cash before the trade can take place. That means that what is risk for the buyer is the potential reward for the seller at the same price. So if you were to sell that same spread at 1.0930, your ticket would show $210 as the maximum potential profit, not loss.

That reward is calculated by taking the difference between your entry price, 1.0930, and the floor, which is shown as 1.0720. That difference is 0.21, or $210. See how the platform does the math for you, but also shows you the exact numbers used in the calculation? That’s transparency.

If the market drops and you are a seller, the floor gives you a natural profit target. You can wait or even set a limit order to exit at or near the floor price of 1.0720.

What if you’re happy just getting part of that reward, say $100? Then you can place an order for 1.0830.

1.0930 (your entry price) minus 1.0830 (your exit price) equals $100. Your order ticket will do that calculation for you as well. You can use the up and down arrows to adjust the price and see the profit for each. When you find the price you want, click Place Order.

Remember that in most cases, you will get filled more quickly when the market has many active participants and you name a price close to the current price.

 

Variable settlement versus all-or-nothing

Unlike binary options, which can only be $100 or zero at expiration, spreads have a variable settlement, meaning it can have a range of different prices.

At expiration, a spread will have a price somewhere within the range. If the underlying indicative market is priced within the range, the spread price will be correlated to that price. If the market is above the ceiling, the spread will expire at the ceiling price. And if the market is below the floor, the spread will expire at the floor price.

So that is where your Nadex spread can end up at expiration: at the floor, the ceiling, or somewhere in between. And your profit or loss is always just the difference between the price at which you bought or sold and the price at expiration. 

 

At this point you should understand:
  • How the price range of a Nadex spread limits risk and reward between a floor and ceiling price
  • How to calculate your risk and reward before you place a trade and how the Nadex platform shows it to you automatically
  • How a Nadex spread is priced at expiration, with a payout somewhere between your maximum risk and reward

 

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You've completed this course.

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