Director of Business Development, Nadex. Currency traders face a multitude of challenges when it comes to risk management. Increased volatility around scheduled macroeconomic announcements, or perhaps worse, surprise announcements or actions, can cause trades to be stopped out in a matter of seconds. Even in what may be considered the less volatile times of day, many traders still struggle with proper stop placement.
Stops too close to the market and the trade may be over before it begins. Stops too far away and the losses can be monstrous. Even with a stop in place, in a highly leveraged market, it is still quite possible to lose more money than a trader may have even had in their account. Take for example the Federal Reserves quantitative easing announcement in March That day, many traders had stops placed on their trades when the market gapped in the neighborhood of pips on many of the major pairs.
When that happened, the stops were not filled at the pre-placed level, but the next available price, which in many cases constituted more money than was even available in their account, setting off collection calls from their brokers. When considering these challenges, traders may want to look toward limited-risk alternatives to the spot market in the form of bull spreads. In some instances, a spread can refer to the difference between two instruments.
For example, the TED spread reflects the difference between interest rates on interbank loans versus short-term US government debt. To an options trader, spread may mean utilizing the same instrument but buying or selling at two different strike prices. An example of this would be a bull call spread, in which call options are purchased at a specific strike price, while also selling the same number of calls at a higher strike price on the same instrument at the same expiration. NADEX spreads are simple, limited risk contracts that are settled against an underlying market and closely resemble bull or bear option spreads.
Essentially, a spread is a price range between two strike prices, which create a floor and a ceiling for the contract. If I think the price of this pair is going up and I choose to buy, my maximum risk is the difference between my buy price and 1. My maximum reward is the difference between my buy price and 1. If I feel that the price of this pair is going down and I sell this spread contract, the maximum risk is the difference between the sell price and 1.
My maximum reward is the difference between my sell price and 1. To clarify, below are a few potential outcomes if I decide to go long, or buy, this spread contract. It is important to note that a trader does not have to hold the contract all the way to expiration and can close out at any point prior to 3: There are easily identifiable advantages for participating in spread trading, either as a stand-alone asset class, or as an addition to an existing currency strategy. The market had been moving up and after a slight pullback was holding along the support line previously resistance around 1.
Thinking that this may represent a good buy opportunity, I was looking to get long euro; however, there were several major announcements due out from both the Eurozone and the US and I was concerned that volatility may kick up quite a bit. For comparisons sake, I have broken out the difference between choosing a spot trade versus a spread trade.
On the spot market, the buy side price of this pair was 1. Before I decide to buy, I have to consider where I would place my stop. The buy price on this spread was 1. The reason for the higher price on the spread trade was due to the optionality of the position. When price is near the floor of the spread, it will most often trade over the market price, when price is near the ceiling of the spread, it will most often trade below the spot price with the closest relationship between the two when price is in the middle of the spread.
By buying at 1. As we can see from Chart 2 the market did move in our favor; however, it did so after a fairly significant initial drop. Depending on our stop placement, the trade may have been stopped out; however, it would just be silly to put a stop that close to support and by giving the market room to breathe the trade would have most likely continued, albeit after a close call.
Even being generous, our best case scenario would have been to close this spot trade around 1. Spread trade — On the initial market dip, there were no concerns about getting stopped out as our risk was protected by the floor of the spread at 1. Our risk was locked in at 24 pips as soon as we placed the trade and even if the market moved pips against us, the trade was still live. Looking at these two trades, the natural question may be: As we can see, from a risk to reward perspective, the spread trade was much more attractive than the spot trade.
Additionally, if we take this one step further, we can look at the return on margin needed to establish the trade. While not every situation is the same and there are no guarantees that any position will be profitable, it is easy to see that in many situations the risk to reward profile offered by a NADEX bull spread position may be more attractive than taking a position in the underlying market. Additionally, because the maximum risk is always set at the time the trade is placed, even if there is a large market moving event that takes place, a trader in a spread position will not have to worry about slippage, or worse, substantial market gaps jumping over the stop.
Please remember that currency, futures, and options trading involve a significant amount of risk and may not be appropriate for everyone. Please ensure that you understand all risks prior to investing. Past performance is not necessarily indicative of future results. If so, the yiel As of August , renminbi RMB in payments globally accounted for 2. The difference between the price at expiration and the initial buy price.
Why Trade Bull Spreads? Fully margined — The total monetary risk associated with a trade is equal to the margin requirement. The boundaries protect the trade so it is impossible to lose more on a trade than was in the account to begin with. This can be a huge benefit in volatile times. Most traders know the feeling of being stopped out after a trade is placed, only to watch it then immediately move back in what would have been their favor.
Same strategies — The same analysis can be used for spreads as what is used when trading the underlying directly. Spot trade versus spread, the numbers:More...