How To Calculate A Nadex Spread Option Risk And Reward
Nadex spreads offered on the North American Derivatives Exchange, or Nadex, are simple derivatives or contracts of an underlying market. A derivative is a simple instrument where the price is derived from something else (like a mortgage is a derivative of a house). Nadex offers spreads on stock indices, spot forex and commodities. Spreads are versatile in that they can be used to trade direction, volatility such as during news events, or with other products as a way to hedge and limit risk from another trade.
Price is determined and driven by the underlying market, not the supply and demand of the spread. Market makers base price on where the underlying market’s price is. An advantage to trading Nadex spreads is the limited defined risk, without being stopped out, should price temporarily move against a position. A spread has the entire duration of its trading time, up until expiration, to move up and down and into directional favor. Typically, it is a low collateral amount to get into a spread trade. In addition, every tick or pip is worth $1 on Nadex. This makes calculating risk and reward simple.
The Ninja Trader chart below shows an example of a spread on the EUR/USD. Every spread has a range with a floor and a ceiling price level, and that distance is the width. A buyer’s maximum risk is the collateral he/she puts up, which, when buying the spread, is the difference between the buy price and the floor of the spread. In the spread shown below, for 1.3819, the maximum risk would be the price 1.3819 minus the floor 1.3800, which is .0019. Therefore, since every pip is $1 on Nadex, the collateral, maximum risk and price of this trade is $19. The buyer’s maximum reward in contrast, is the difference between the buy price and the ceiling. The maximum profit for a buy on this trade would be the difference between the ceiling 1.3900, and the price 1.3819, or .0081 pips, so $81. The green on the bought side of the clip shows the maximum reward, and the red shows the maximum risk on the spread.
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A seller’s maximum risk is the collateral he/she puts up, which when selling the spread, is the difference between the sell price and the ceiling. When selling the above spread for 1.3819, the maximum risk would be the ceiling 1.3900, less the price 1.3819 which is .0081. Therefore, the collateral, maximum risk and price to sell this spread is $81. Again, in contrast, the seller’s maximum reward is the difference between the sell price and the floor. The maximum profit for selling the above spread would be the difference between the price 1.3819, and the floor 1.3800, or .0019 pips so $19. The red on the sold side of the clip below shows the maximum risk and the green indicates the maximum profit on the spread.
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