From the December 01, 2010 issue of Futures Magazine • Subscribe!

Spreading forex risks with Nadex bull spread

Spot forex has faced a great deal of criticism regarding risk. Critics point out that forex markets are the arena where central banks, sovereign wealth funds and global transactions dominate, reducing the retail trader to "noise" in the market bound to be on the losing side. A rumor about or comment by a central banker generates a reaction in the spot markets that can sweep away what may have been reasonable stop positions. The most common risk in spot forex is misuse of the high level of available leverage.

High leverage in spot forex is a very combustable combination. Until recently, firms were offering 400:1. With this leverage, a trader having $1,000 was able to put on a 400,000 EUR/USD trade. At this position size, every pip is valued at $40 and a 25 pip loss wipes away the account! The new Commodity Futures Trading Commission rules have lowered the maximum to 50:1. Even at 50:1, the risks of being on the wrong side of a trade remain quite high. Consider that the one-hour average true range of a currency pair such as the EUR/USD is often greater than 30 pips, and it is clear that leverage still can be abused. But a new instrument designed by the North American Derivatives Exchange (NADEX) attacks the stop-loss problem. Nadex calls it a bull spread, though it more accurately would be called a vertical spread as it can be traded in either direction. Nadex provides a spread contract for the EUR/USD, GBP/USD, USD/CHF, USD/CAD and USD/JPY. The contract always provides a support or floor and a ceiling or resistance level that creates a trading range. For example, the EUR/USD has a 100-pip range on the two-hour spreads. There are firm expiration times at two-hour intervals during the day.

Tactically, trading the spread requires similar skills as trading spot in terms of analyzing the market fundamentally and/or technically. Yet, a significant difference is the burden on timing skills. The spot trader has to be very adept at timing entries and exits as the risk of being stopped out looms large. In contrast to spot trading, there is no sudden stop loss risk in the duration of the spread trade. Your risk is limited to the parameters of the spread. Because the spread trade expires at a defined intraday time, any price movement — below the floor for buyers or above the ceiling for sellers — is irrelevant and will not trigger a loss. The trader cannot be stopped out, so you maintain your opportunity for profit even if those parameters are breached prior to expiration.

The trader could be buying or selling. For example, consider a EUR/USD spread contract that would be 1.3870–1.3970, expiring at 6 a.m. EST. Let’s assume the spot is at 1.3890. The trader buys the spread believing it will go up. If the trader is correct and the EUR/USD goes to or above contract ceiling (which is 1.3970) the maximum he will make is 80 pips — no matter how high it goes. Also, if the EUR/USD goes below the floor to 1.3850 the maximum he will lose is the difference between the entry and the floor, or 20 pips. The spread works exactly the same for sellers anticipating a downward move. Obviously, it’s a good idea to enter buying off the floor and selling off the ceiling, but the important point is that in either case your risk/reward is clearly defined.

From a leverage point of view, we have another interesting effect. To put on the Nadex spread, the trader has to have the equivalent of the maximum exposure of that trade. With a buy price of 1.3890 and a floor of 1.3870, there is a 20-pip difference between the buy side and the floor. At $1 per pip, the maxiumum loss and thus collateral required in the account is $20. This also means that in comparison, the spread has a margin requirement one-tenth that of the same spot forex trade. No one should place trades with a 100% margin-to-equity ratio, but this allows you to be precise with your risk parameters; no need to calculate for slippage.

Another important benefit is the ability of traders to use the Nadex spread to trade data releases such as the employment report, which commonly produce whipsaw action in the market that causes stops to be initiated, often with extreme slippage, before moving back in your favor (see "Hold onto opportunity"). The Nadex spread allows the trader to enter before the news release and avoid the effects of whipsawing markets.

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The Nadex spread contract, by offering option features such as an expiration deadline and strike prices, allows traders to focus on direction while containing risk.

Abe Cofnas is the author of "Sentiment Indicators" (Bloomberg Press). He can be reached at abecofnas@gmail.com.

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.

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