Using Spreads to Trade Volatility

In this lesson:
  • How do you calculate the maximum risk and profit potential of spreads?
  • Why is the price of a spread greater than the underlying futures price? What is the added cost for? 
  • How do you use combinations of spreads to profit from different directional moves?

Volatile Markets

You have heard how Nadex spreads and binary options offer you limited risk, but choosing the right spread or binary strike price is important if you want to get the maximum reward.

When the market seems to be volatile, some take cover, but others see opportunity. Volatility means big price movement. If you can trade with the trend of that movement, you can reap big rewards.

Picking the market direction, however, can be difficult. Nadex spreads let you trade direction within a limited range and with protection against being wrong. That protection is different and perhaps better than a stop-loss order, because you won't be knocked out of a trade position no matter how far the market moves against you. You can even create positions that will profit in either direction.

You should remember that spreads are also options, like binary options. So when volatility increases, spreads cost more, because their profit potential increases compared to less volatile conditions. 

If you’re familiar with conventional options, you may know the “Greek” term Vega, which measures how changes in volatility impact the option pricing. When market volatility increases, so does the Vega of the spread.

Choosing the right spread starts with choosing a direction

If you’re expecting more volatility, you’re probably looking for a big move. For big moves, you'll want wider spread ranges with longer durations. Those give the trade more hours to develop.

The shorter durations (2-hour) have narrower ranges and smaller profit potential. However, you are not paying for extra hours which you won't use. You expect the move to happen within two hours, so you pay only for that time premium.

Controlling risk and buying time are the two big benefits of Nadex spreads. Let’s look at an example using the daily spread for the US 500, based on the E-mini S&P 500 futures. These spread contracts are listed at 6:00pm ET and expire the next day at 4:15pm ET.

To put yourself in the best position to profit, you would buy the Nadex spread when its price is near the floor or sell when its price is near the high strike, or ceiling.

Your maximum risk is easy to calculate: it equals the amount you pay to initiate your position plus transaction fees. That is the total amount you can lose. You won’t face any additional costs. Here you are buying the spread, so your cost is the price difference between the low strike (floor) and your trade price, multiplied by $1 per tick.

Another way to look at the spread price is as the break-even. You just need the spread to go above it if you're buying, or stay at or below it if you're selling, to have a profitable trade. Like a binary option, the buyer’s and seller’s initial costs add up to the full dollar value of the spread range.

When looking for a big move with higher volatility, you may try to initiate trades with a lower cost, for less risk. Such trades would be considered out of the money (OTM), meaning the market would have to move further in your direction for the trade to break even (at the money) and then become profitable (in the money).

If we were bullish about the S&P 500 stock index, for example, we might buy the spread called the US 500 (Dec) 2010.0 – 2050.0 (4:15pm) listed at 6:00pm the previous evening. Let’s say that the underlying market, the CME E-mini S&P futures, is trading at 2011.00.

In that case, the Nadex spread price might be quoted at 2019.10 bid / 2019.50 offer. Notice that the spread price is higher than 2011.00. You pay a premium to buy time for the trade to develop and become profitable.

If you bought the offer price at 2019.50 your initial cost would be $95 per contract (2019.50 -2010.0 = 95 pts * $1 per tick). By comparison, one full point or handle on the E-mini S&P futures is $50 per point. One point in the Nadex US 500 spread is smaller, only $10. And unlike the e-mini S&P futures, you can hold your position overnight with no additional margin or cost. At Nadex, there is no margin. You pay for the trade up front.

The difference between the spread price and the underlying futures price is the time and edge you’re giving up in exchange for profit potential. Think of it like giving the market a head start, in exchange for an affordable cost of entry.You need the futures price (2011.0) to rally to at least 2019.50 at expiration to break even. The other side of the trade is the seller, who pays $305 to make $95. The seller pays more for a more favorable position at the start.

Since the futures price is one point above the floor of 2010, the spread has one point ($10) of what’s called “intrinsic value.” Part of the initial $95 cost is that $10.

Let’s look at the numbers. If the E-mini S&P futures expires at 2011.0 then your long spread position will lose money. The difference between your entry price and the underlying futures is $85 per contract (2019.50 – 2011.0). That is the edge you give up. The value of the spread if it expired right at that time, would be $10 per contract (2010.0 – 2011.0). That’s the intrinsic value.

You will profit once the spread’s value goes above 2019.50, and you will continue profiting up to the top of the range at 2050. The maximum profit that could be made in this example is $305 per contract (2050.0 - 2019.50).

Profit in either direction using combinations

Volatile markets can make it particularly hard to tell what direction the market is going. By buying and selling OTM spreads in combination, you can set yourself up to be able to profit from a move in either direction, up or down, while still having the risk protection the spread gives you.

So after buying the above 2010-2050 spread, you could also set yourself up to profit from a downside move by selling the US500 (Dec) 1970.0 – 2010.0 (4:15pm) listed at 6:00pm. Let’s say it is quoted at 2001.70 bid / 2002.10 offer.

Assume you sell the spread at the bid price of 2001.7. Your initial cost would be $83 per contract (2010.0 - 2001.7 = 83 pts * $1 per tick).

Your maximum potential profit for this part of the combination is $317 if the market trades down to the floor at 1970 (2001.7 – 1970.0 =317 pts * $1 per tick). Note your initial cost for this OTM spread is cheaper because the spread has no intrinsic value yet. The underlying futures price at 2011.0 is above the 1970.0 – 2010.0 spread range.

By combining both spread positions, you can benefit from big price movement in either direction. The tradeoff is that your profit potential has been reduced because you have increased costs. Now you’re paying for two trades rather than one.

Bought US500 (Dec) 2010.0 – 2050.0 (4:15pm) Cost: $95
Sold US500 (Dec) 1970.0 – 2010.0 (4:15pm) Cost $85
  Total $180

So what could happen with this combination of spreads at expiration?

If you have a big up move in the market, you would break even once the futures price reached 2028.0. Above that price, you would profit. The range value of US500 (Dec) 2010.0 – 2050.0 is $400 so with your combined initial costs at $180, the maximum potential profit would be $220 (400 - 180).

If you have a big down move in the market, you would break even once the futures price reached 1992.0. Your profit zone would be below 1992, down to the floor of the spread you sold, which is at 1970. The range value of US500 (Dec) 1970.0 – 2010.0 is also $400. Here, too, you would subtract your combined initial cost of $180 to give you a maximum potential profit of $220 (400 – 180).

Notice how the profit calculation is simpler when you are dealing with a fixed cost of entry. You just subtract your total cost from the full range of the spread.

Your worst case scenario is if the futures is trading right at 2010.0 at expiration. So a sideways market is not what you want. However, you can always exit the trade before expiration, so if the market makes a move before coming back to 2010, you have a profit opportunity there. At 2010.0, neither spread would have any intrinsic value so you would lose your combined initial $180 cost. Again, you won’t have any further costs, other than the exchange fees.

Note: exchange fees not included in any of the calculations above

 

At this point you should understand:
  • How to calculate the maximum risk and profit potential of a spread or combination of spreads
  • Why the price of a spread is not the same as the underlying futures price and what that added cost represents
  • How to use combinations of spreads to be able to profit whichever direction the market moves, except sideways

 

 

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