A bull spread is a simple derivative with built-in floor and ceiling levels that define the lowest and highest points at which your trading position can settle. This means you’ll always know your maximum potential loss and profit from the outset.
Bull spreads are short-term contracts settled based on an underlying market, making them an acceptable alternative for speculating on market movements or hedging the risk of other positions. Nadex offers bull spreads on stock index and commodity futures, but the most popular are those on forex pairs.
Using bull spreads offers several benefits because they are ideal for the retail trader looking for limited risk while trading in volatile markets. Nadex offers multiple spread ranges in each market giving the trader flexibility to choose the appropriate risk-to-reward ratio given their underlying market bias.
One of the greatest benefits of using Nadex bull spreads is the absolute control of risk. Because there is an upper and lower boundary, the trader always knows his maximum potential loss before the trade is placed. The amount of risk on the trade is also always equal to the collateral required to secure the trade which means there are no margin calls and a trader cannot be called upon to deposit more funds in the advent of a fast market move. Because of the spread boundaries, whether the trader has a long or short market bias, he can never lose more than the initial cost of the trade, under any circumstances. This can be a huge benefit in volatile times when the market is moving adversely to your position.
Another benefit to bull spreads is the trader does not have to use a stop order. 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. With a bull spread, the floor of the contract limits losses for long positions, and the ceiling limits the losses on short positions without “stopping out” the position. The trader using a spread is effectively buying time to be right and is able to withstand those quick adverse market moves.
Unlike option-spread strategies that require multiple “legs,” the Nadex spreads are in a single-leg and are similar to a vertical option spread. Because they are traded in a single unit, they may offer a simpler alternative to traditional option spread strategies and may also reduce brokerage costs. Additionally, because they are traded in a single-leg, this limits the bid/ask differentials paid to one, rather than two or more.
A typical bull spread might have a title like: EUR/USD 1.3000-1.3250 (3PM). The figures represent the floor and ceiling levels for the contract.
In this example, your trade will settle based on the underlying EUR/USD spot rate, but because of the contract’s floor and ceiling, that can be no lower than 1.3000 and no higher than 1.3250, at 3 p.m.
To open a position, you buy or sell at Nadex’s prevailing bid or offer price. This price is based on spot EUR/USD relative to the boundaries of the particular spread range. The Nadex pricing will always be somewhere inside the floor/ceiling range. Initially when the spread contracts are first trading, there are 3 different ranges listed which amount to ITM, ATM and OTM option spreads. You buy if you think the underlying market price will rise, or sell if you think the price will fall. On Nadex you’re trading a derivative so the Nadex spread price is really your breakeven price where you need the underlying market to be above or below.
During the life of the contract, the underlying market can move for or against you, but the floor and ceiling levels shield you from movements beyond these predetermined limits. As with any of the Nadex contracts, you can also choose to close out of the position to take profit or limit a loss before expiration.
Bull spreads allow you to trade a wide array of markets with defined risk, often with low collateral requirements and allows for multiple daily trading opportunities.
To get you started, Nadex even offers a free demo account to allows you to test drive the Nadex trading experience.
Next week we will cover a couple of specific examples.