Buying the Stock Market Using Spreads

1. Choose your market and expiration

Nadex spreads give you fewer expiration choices compared to binary options but the dollar value of the spread range is usually much larger. In this example, our market expectation is bullish. We think the stock market, specifically the E-mini S&P 500® index futures price is going to rally to around 2000.00 by the end of the day’s trading session. We are looking to limit our downside risk and look for a lower cost trade. As you can see from the chart, the market has had a slight retracement of its 50-point rally. This seems like a good level to go long (buy) before a potential continuation up through 2000.00.

The chart below shows the Indicative Index price of the Nadex US500 contract, which is based on the CME E-mini S&P 500® futures. We continuously calculate the indicative index price using the last 25 futures trades as the sample set. This reduces anomalies and creates a reliable price for trading. We use the same calculation for the expiration settlement price.

Your spread trade already has the built-in protection of knowing your maximum possible loss up front. Where a binary option’s expiration value will be either zero or $100, a spread’s value can vary from the lowest value of the range up to the highest, with incremental values in between.  

You can also choose to exit the spread trade any time prior to expiration to take an early profit or cut your losses. If however the underlying market goes below or above the spread range, the price is limited to the low and high strike prices.

2. Buying the spread near the floor

The 3 colored boxes above represent each spread contract’s floor and ceiling. The lowest, for example, is the US 500 (Mar) 1940.0 – 1980.0 spread.

As you can see the underlying market price (E-mini S&P) is around 1977 and we’re looking for the futures to rally into the shaded area representing the 1980.0 – 2000.0 spread. When you initiate a spread trade, your spread price and the underlying price will likely be different. A way to think about it is, the Nadex spread price is your actual breakeven; it is where you need the underlying market to be at expiration to break even.  Obviously you want the underlying market price to be higher than the spread price where you entered, in order to be profitable.

3. Place your order

At 11: 55 am you decide to buy the US 500 (Mar) 1980.0 – 2020.0 Nadex spread. The other spread choices would be more expensive with less profit potential. The reason they are more expensive is that the market is already inside the range of those spreads. This spread has 4hours 19minutes remaining until expiring at 4:15pm ET. Its initial cost is comparatively low because the underlying market is still about 3 points below the floor of the spread.

The order ticket below displays the best bid and best offer. On Nadex you can place limit orders or market orders with protection (MOP) which let you enter at the market but define a tolerance limit for your fill price. This prevents being filled far from where you intended.

The order ticket below shows the following order:

Buy 1 contract of the US500 (Mar) 1980.0- 2020.0 spread at 1984.2

The order ticket shows your Max loss and Max profit. The max loss is the initial trade cost of the spread position, like binary options. The dollar range value of this spread, however, is $400, the difference between the high and low strike prices (2020.0 - 1980.0 = 400 ticks) where the minimum tick value 0.1 equals $1.

The cost reflects the risk exposure of the spread position. Since we are buying the spread, our risk comes if the market goes down, so the initial cost is limited to the difference between the current Nadex spread price and the lower strike of the spread, or floor. If the spread price is 1984.2 and the lower strike (floor) is 1980.0, the cost and maximum risk of the position will be 42 ticks or $42.

The maximum profit occurs if the underlying market rallies to the upper boundary of the spread range (ceiling). If the market goes even higher at expiration, the maximum profit is still capped at the difference between the price at which you entered and the ceiling. As you can see on the order ticket above, the Max profit is $358 which is the difference between 2020.0 (high strike) and 1984.2 (entry price).

On Nadex trading fees and expiration fees are 90 cents per contract for the first 10 contracts in an order. Larger orders will still only be charged $9. So in this example, the total cost to enter the trade was $42 + 90 cents or $42.90. When you exit the trade, either early or at expiration, you’ll get a second fee of 90 cents (called a trading fee or expiration fee).

4. Manage your trade until exit or expiration

We entered the trade around 1977, or 3 points below the floor, with 4 hours 14 minutes to expiration. That 3 point edge which you give up is why your initial trade cost is low relative to the potential maximum profit if the underlying market trades higher.

Near the floor, the spread price is less sensitive to the underlying price movement. In other words, while the underlying moves from 1977 up through 1980, the spread price won’t move much or at all. The spread behaves much like an out-of-the-money option.

Below you see the Open Positions Window overlaid on the chart. Note the Indicative price is now at 1982.183 which means the underlying market rallied almost 6 points. Meanwhile the Nadex spread price is 1984.1 bid, noted in the current market tab. That is the price at which you would be able to sell your spread right now, with 3 hours left until expiration.

About an hour and a half later, the market has gone up over 5 points, though the spread price is still unchanged, because the price is so close to the floor of the spread range. 

 

But as the price continues higher, the spread price moves in closer correlation with it and also goes higher. The trade is now profitable. 

Two hours later, both the underlying market and spread price have gone up further:

In this real market example, the US 500 happened to continue upward as we predicted, reaching 1991.500 with about 19 minutes to expiration.

 

Not all trades will work out like this. If the underlying market had gone down your initial trade risk would have been limited to the initial cost of the trade. As the market rallies into the middle of the spread range, you will typically see a greater correlation between the spread price and the underlying price. Near the floor and ceiling, or outside the range, the correlation is less.

Spread Price Correlation to Underlying Indicative Price
Time left Nadex price Change Indicative Price Change

4:29

1984.2   1976.75  
2:55 1984.1 -0.1 1982.183 5.433
2:25 1986.5 2.4 1986 3.817
0:35 1988.4 1.9 1989.083 3.083
0:19 1990.7 2    

In this example you had plenty of opportunities to close out the trade for a profit. If you hold your position until expiration, you will receive an email from the exchange informing you that your position has settled. Below is the email for this example, which we held until expiration. As you can see, $108 was deposited into your account. Since your initial cost was $42, your profit is $66 (108-42). Subtract $1.80 from that and your net profit per contract is $64.20. 

 

Your position in the US 500 (Mar) 1980.0-2020.0 (4:15PM) contract has settled. The details of your settled position are shown below for your reference:

Settlement Details:
Contract: US 500 (Mar) 1980.0-2020.0 (4:15PM)
Quantity: 1
Expiration Value: 1990.800
Payout Amount: $108.00

Your positions and account balance have been updated accordingly.