- The risk/reward profile of Touch Brackets
- How defined risk determines capital requirements
In the previous module, 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. In this module, we will learn how this structure translates into the risk/reward profile of a trade and how this then translates into the capital requirements for placing the trade.
Let’s start with risk
One of the biggest benefits of a Touch Bracket for any level of trader is defined risk. This puts the trader in control and never leaves them stressing about the unknown risk factors so common in leveraged markets.
The risk on every trade is defined by the floor or ceiling. For buyers, their maximum risk is the difference between where the contract is bought and the floor of the contract. For sellers, their maximum risk is the difference between where the contract is sold and the ceiling of the contract. And, since a Touch Bracket can never trade beyond either of these two points, both buyers and sellers know with 100% certainty, before placing the trade, what their maximum exposure is. The floor and the ceiling are basically contractual stop levels. Because they are contractual stop levels, the trader never has to worry about slippage or losing more than they were will to risk on a trade.
On the reward side, this is also defined by the floor and ceiling. For buyers, their maximum profit potential is the difference between where they bought the contract and the ceiling level. For sellers, their maximum profit potential is the difference between where they sold the contract and the floor level. Now, you may be asking yourself, “Why would I ever want to put a cap on my potential reward?” That is a great question and I am glad you asked it.
The main reason is an exit plan for every trade. This is a key concept of successful traders. They know the maximum loss they are willing to take, but they also know they need to have a plan to take profit. The road to trading is littered with the busted accounts of would-be traders who chose greed rather than a sensible exit plan. With a Touch Bracket, an exit plan is included directly in the structure. Additionally, if the market moves really fast and touches your maximum profit potential level, your profit is automatically locked in, saving you from potentially missing the opportunity to lock in gains before the market turns.
So how does all of this translate into the capital requirements for trading a Touch Bracket? That part is simple. The maximum risk on any trade is equal to the capital required to enter that trade. Rather than a margined-type contract such as futures or forex, Touch Brackets are fully collateralized up to the amount of risk each party has on the trade. Also, since this amount is determined at the time the trade is placed, this amount never changes. Unlike what is so common in the futures markets where traders have to drastically increase margin to hold a position overnight, the capital required to hold a Touch Bracket position never changes, which makes it just as easy to swing trade these contracts as to day trade.
Lastly, because the capital required is based solely on maximum risk, it is possible for a trader to receive the benefit of very substantial leverage, without the fear of losing more than they ever expected.
Let’s take a look at an example
Here we have the US 500 Touch Bracket. In this example the current Indicative Underlying Index is at a level of 2720.00. The Touch Bracket in this example has a floor of 2710.00 and a ceiling of 2760.00. The total range of this contract is 50 points which equates to a total value of $500.00
If this contract is bought at 2720.00, the maximum risk is the difference between the buy price of 2720.00 and the floor of 2710.00 which is 10 points. In the case of the US 500 this equates to $10.00 per point or a total risk of $100.00. That $100.00 is equal to the capital required to place the trade.
The maximum potential return is the difference between the buy price (2720.00) and the ceiling of the contract (2760.00). In this case that would be 40 points or $400.00 (not inclusive of exchange fees).
Of course, you do not have to hold a position to the extreme points, but may try to close the trade early to limit losses or lock in profits.
The risk and reward profile and capital requirements for placing a Touch Bracket trade.
How well do you know Nadex Touch Brackets?
In the next lesson we will tie it all together in a trade example.