Bull spreads are ideal for the retail trader looking for a way to participate in the price action from the underlying market while benefiting from the boundaries of the limited risk exposure.
Bull spreads are short-term option contracts of one day or less in duration in which the underlying is based on spot FX, stock index and commodity futures. The Nadex spread is a simple derivative that has a built-in floor and ceiling level that defines the boundaries of your market exposure based on the pricing of the underlying market.
This means you’ll always know your maximum risk and potential profit from the outset of the trade.
The grain markets provide a very good use study for these types of contracts.
Despite technological advances, farmers ultimately remain at the mercy of nature.
Crops can be severely affected by extreme temperatures, as well as droughts and floods. For active traders in these markets, trading grains can be extremely stressful. The unpredictability of the forces of nature can spike volatility and create wild price swings that can lead to losses far greater than a trader expects. This type of volatility also can be created just from the prediction of adverse weather, which may effect crop production.
While we can never tame mother nature, as traders we can tame the risk we take on trades, while still finding opportunities where we may profit.
Let’s look at a hypothetical example:
The National Weather Service is expecting a drought across most of the country next summer. You realize this won't affect the corn yield until next year, but the news itself could have an immediate impact on corn prices, causing them to rally.
In this example, we will look at a Corn Nadex Spread with the underlying corn future trading at 580.
You believe the price of corn will rise in reaction to the news and are looking for a target price of 609-612.
You choose to buy corn contracts (March) 570.0-610.0 (2.15 p.m. ET) because you think the price of corn futures will rise during the day after this trade is initiated, at which point it has an offer price of 583.1.
The “floor” and “ceiling” are set at 570 and 610 respectively, so for one contract if we buy at the offer price the initial cost is $131 (583.1-570). Using the spreads the most exposure that we have on corn to the downside is the 570 level, which is the initial cost of the trade.
To breakeven on the spread trade, the price of the underlying corn futures only needs to move to 583.1 and anything higher is profit all the way up to the ceiling price level of 610. The price difference between our entry price of 583.1 and ceiling price of 610 is 26.9 points at $1 per tick, which would generate a $269 maximum profit potential per contract. So, in this example, the trader buys 5 contracts with the initial cost of $655 with a maximum potential profit of $1,345. This position will expire at 2:15 p.m. ET.
The difference between Nadex' expiration value and your opening price of 583.1 will determine your profit or loss within the limits of the cap and floor level strikes.
You make a profit if at 2:15 p.m. the Nadex expiration value for corn had risen above your opening price of 583.1. The expiration value for corn is 604.2, which is shy of our target levels but higher than our entry spread price. The trade profit is the difference between the opening price (583.1) and the expiration value (604.2)--which is 21.1 points or $211/contract.
Initially 5 spread contracts were purchased, so the total profit on this trade is $1,055 ($211 x 5 contracts).
This is lower than your maximum potential profit because the settlement price fell short of the spread’s ceiling of 610.
If, however, the expiration value for corn was $579.6, below your opening price, then you would take a loss. The difference between your opening price (583.1) and the settlement price (579.6) is 3.5, or $35 per contract or for 5 contracts a $175 loss.
Note that if the corn market had fallen out of bed and had a Nadex expiration value below the 570 floor, the loss on the trade would be limited to the initial cost of the trade, or $131 for 5 contracts.
*Note that exchange fees were not included in this example.
While losses will always be a part of trading, by using a Nadex spread contract, traders can have the comfort of knowing with 100% certainty what their maximum risk is on any given trade is and the knowledge that they will never be called on for additional funds or face the dreaded margin call.
In September we will take a more direct look at bull spread trading.