The Scream – Edvard Munch (1863–1944)
Yesterday saw the much anticipated announcement from the FOMC of a hike in the fed funds futures rates and the market initial reaction could have caused some traders to experience heavy losses. This is something that futures traders understand all too well. After catalyst events like yesterday’s FOMC announcement it can be very risky for traders to hold positions in outright futures. The initial reaction can often be violent, leading to slippage and causing a trader’s stop loss orders to fail. This can lead to a larger loss than the trader intended and can have serious consequences for their account. Luckily there are other derivatives contracts a trader can use ahead of these events to prevent outsized losses and develop a well-defined risk and reward setup ahead of these events. One such product available to traders is Nadex Spreads.
A Nadex Spread trades much differently than the binary options you are probably more familiar with. Nadex Spreads are listed in a wide range of markets and offer a trader a limited risk approach to trading the movement in popular markets. The spreads trade at a much smaller tick value than their underlying futures and give a trader with a smaller account the ability to make speculative plays in indices, commodities and currency pairs. Let’s look at an example of a spread to illustrate its benefits.
With CME E-Mini S&P 500 futures trading at 2261.50
Buying the US 500 2210-2290 Daily Spread is trading at 2261.80
Risk: $518 per 1 lot
Reward: $282 per 1 lot
As you can see this is a much smaller contract compared to the underlying futures. CME E-Mini S&P 500 futures have a contract value of $50 per point whereas the spread is only worth $10 per point. This means that a trader can risk 20% of what they would need to in a 1 lot of the futures to trade the spread. This makes it far more accessible for trader with under-capitalized accounts. You can also see that the spread has a built in floor and ceiling level. These are levels that the spread cannot settle outside of. So if a trader is long this spread and the market slams lower they know they can never lose more than $518 per 1 lot. There is no way to replicate this in the futures market.
Since the spread cannot settle outside of certain values it makes them ideal for trade setups ahead of catalyst events like the FOMC announcement. The traders risk is essentially managed as soon as they enter the trade. The spread also gives the trader staying power that they would not have in the futures. To manage risk in futures a trader must use a stop loss, but if that order is hit they are taken out of the trade. To participate in any rebound they would need to reenter and add risk to the position. The floor and ceiling in spreads allows traders to stay in this position and participate in any reversals without adding risk, again making them ideal for catalyst events.
If you have ever been caught in a position that was the victim of slippage or wide markets after a catalyst event you should sincerely consider trading Nadex Spreads, you will find the risk management capabilities and the scalability of the contracts to be a huge benefit.
Note: Exchange Fees not included