Trade Crude Oil Futures with Nadex Call Spreads for Protection
Protect futures trades with Nadex Call Spreads instead of, or along with stop-loss orders for greater staying power.
1. Choose your market direction, trade target and risk level
From the chart below you can see that crude oil has been in a downtrend for many months. The market has recovered since mid-January but the $38 level crude could be tough to crack. You want to sell the crude futures at 38.16 with a profit target at $36.00. You plan to cover the position by the day’s close. In other words, you won’t hold the position overnight.
Note the chart pricing is the Nadex Indicative pricing based on the price of the NYMEX® Crude Oil Futures contract using a continuous 25 trade sample set for the calculation.
Trading crude oil futures can be exciting. But the leverage usually means you need to keep your stops tight. You do that to keep your losses small, which is always important. At the same time, tighter stops are more likely to get triggered, meaning you get stopped out more often. This is an eternal balancing act for futures traders.
Leverage is a good thing when the market is going in your direction but painful when you’re on the wrong side. Every 0.01 tick is worth $10 per contract in crude oil futures. It can add up quickly.
You have to find a trading style and profit/risk ratio that you are comfortable with, so you might handle this trade differently than we do in this example. But the principles will be the same. We will say our risk tolerance is $500. That’s how much we’re willing to lose if we get stopped out of our short position.
That means setting your stop-loss order at 38.66. Your return to risk ratio (RR) is thus 2160:500 or 432%.
2a. Trading a futures contract
You are short one crude oil futures contract at 38.16. (“Short” means you have sold first and will exit by buying back.) The position could theoretically profit all the way down to zero, but your profit target is 36.00 by the day’s close. That equals 216 ticks or $2160 profit if the market drops to your 36.00 target.
Every tick the market moves against your short position you are losing $10. Your stop loss is at 38.66. If crude rallies 50 ticks, your stop loss order will be triggered. If you have no slippage (and we hope not) you’ll have a $500 loss on the position. If there is slippage, your order may get filled with an even greater loss.
As you can see from the chart above, crude oil can have big price swings which can stop you out of the trade early, even though you were right about the overall direction. Let’s look at an alternative to stop-loss orders, one that lets you limit your losses without getting stopped out of the trade and without the risk of slippage.
2b. Adding Nadex call spreads for protection and staying power
Instead of using stop loss orders for protection, using an out of the money (OTM) call spread can give you a hedge against loss while letting you stay in your position longer. You get protection and staying power. Again, let’s say we are short the futures contract at 38.16. Below are some of the crude oil call spread choices you can consider.
Call Spreads are available at different times with different ranges. Depending on when you implement the futures trade protection and what call spread price level you choose, your cost and amount of protection will vary. Let’s look more closely at our choices
3. Looking at your order choices
Unlike a stop-loss order, a Nadex call spread charges you its full cost up front. This is a tradeoff you must consider. A stop loss order costs nothing up front. But if it gets triggered, you take the full loss and you get forced out of your position.
A Nadex call spread, on the other hand, is paid for up front. You can never lose more than that amount. But that protection can often cost less than the $500 a stop-loss would cost you if triggered. Even better, that call spread can also end up giving you additional profit above the profit from the futures trade, as we’ll see.
We are looking to buy call spreads that offer best protection for the lowest cost. The closer the call spread strike level is to the futures price, the better the hedge protection with less slippage. The three call spread contracts below all offer protection beyond the 38.66 level you’d get with a 50-tick stop loss.
Short 1 Crude Oil futures contract at 38.16
Buy 1 Crude Oil (Apr) 38.0- 43.0 call spread which is offered at 38.51 expiring at the end of day
Buying 1 contract at 38.51 results in $51 cost with protection up to 43.00 vs 38.66 stop
Buy 1 Crude Oil (Apr) 38.0- 41.0 call spread which is offered at 38.53 expiring at the end of day
Buying 1 contract at 38.53 results in $53 cost with protection up to 41.00 vs 38.66 stop
Buy 1 Crude Oil (Apr) 38.25- 39.75 call spread which is offered at 38.47 expiring at 10am ET
Buying 1 contract at 38.47 results in $22 cost with protection up to 39.75 vs 38.66 stop
The Nadex Crude Oil call spread is based on the price of the NYMEX® Crude Oil Futures contract. The leveraged crude oil futures contract’s minimum .01 tick is equal to $10 per tick. The Nadex call spread contract has the same minimum .01 tick but the value is $1 so we’ll buy 10 Nadex contracts to match the $10 amount per tick.
We decided to wait and see if the market broke down as expected. Remember to subtract the cost of your call spreads from your calculations of maximum profit potential. In the next section, we’ll also look at adding additional spreads to lock in profits, as an alternative to a trailing stop-loss order.
3. Place your order
As you see from the from the chart below, the crude oil futures price has slowly sold off to around 37.68 for an unrealized profit of $480 (38.16 - 37.68) or 48 ticks. You’re getting a little cautious and ready to lock in some protection using a call spread. Since the price movement has been less than expected you decide to use the shorter duration call spreads which will likely cost less than longer durations but offer less price range protection.
As you can see below from the order ticket, the Crude Oil 37.50 - 39.00 call spread has a range value of $150 between strikes. It costs $23.00 to buy and has 1 hour 48 minutes until expiration. This strategy means that your futures position has protection up to 39.00 if the crude oil rallies, but will continue to profit if the crude oil happens to have a big sell off by the close. This should give you staying power.
We bought 10 Nadex call spread contracts at an average price of 37.721 and a cost of $221.00. Once again, it takes 10 call spread contracts to match the $10/tick movement of one futures contract. The crude market rallied soon after. Here is a snapshot of the combined position with 3 minutes 5 sec before the spread contract expires.
We decide to hold the call spreads until expiration since they are profiting from this rally. Once the call spreads expire, your futures position will no longer have a hedge so it may be wise to close the futures position as well.
On expiration and settlement, you receive a confirmation email from the exchange:
The Crude Oil (Apr) 37.50-39.00 (1PM) contract has settled.
Contract: Crude Oil (Apr) 37.50-39.00 (1PM)
Expiration Value: 37.890
Payout Amount: $390.00
Here are the combined results of your futures trade and your Nadex call spread trade. In this case, both ended up profiting.
Long the Nadex call spread: $390 proceeds received at expiration - $221 cost = $169 gain
Short the Crude Futures at $38.16. Assuming you closed your position at 37.89 = $270
Combined position resulted in $439 total profit.
What if you had done this strictly as a futures trade? At the market’s low point, your short crude position on its own was up $660. Theoretically, you could have taken profits there, but that would require you to pick the bottom precisely, which is difficult to do. More likely, you would have trailed your stop-loss and gotten stopped out with part of that $660 as profit. And once you’re stopped out, if the market drops any further, you are no longer in the trade.
Using the call spread, you had similar profit protection up to $39, but you also were able to remain in the trade for another 1 hour 48 minutes. If the April Crude Oil futures fell out of bed during that time, you would have still been in the trade.
Note: Exchange fees not included in calculations.