Using Spreads As The Ultimate Hedge Strategy
If you are a futures or forex trader there is a strategy to reduce your risk.
Sometimes stock traders buy puts to hedge their risks, but what about forex or futures traders? This article will explain using Nadex Spreads as a hedge against risk for futures and forex trades.
Typical Trading Example
The chart above is the GBP/USD, but it could be any market. You plot a trend line and see a bearish trend. You identify a pullback for an entry signal. You exercise caution and set your stop/loss above the highest candlestick. Your risk is 65 pips or $650, so you are prudent in setting your stops.
Then this happens:
The market starts threatening your stop/loss.
What do you do? Do you move your stops and take the hit? On the other hand, do you go long because there is a trend reversal?
The worst part about it is that it is a slow, agonizing march toward your stop/loss. You decide to take the hit, losing $650, but then the market slaps you in the face!
Your initial instincts were right! The market was in a downtrend, but then it spiked upward and stopped you out before it made its move downward.
The net result is a loss of $650. This article will show you a strategy that will prevent this from ever happening in the future. You will learn how to place the exact same trade, use less money and never get stopped out again. You can combine this strategy with your current forex strategy to create a massive stop/loss for a fraction of the cost.
To make money in trading, you need to master three things:
1. You need to learn to reduce your risk.
2. You need to increase your leverage.
3. You need more time to be right.
In the example shown above, the trade had $650 at risk. As soon as you placed the trade, the market spiked and took you out. You were right, but you needed more time to be right.
Trading futures, options and forex can be very expensive. Traders can be required to have upwards of $30,000 on hand to fund their accounts and have considerable amounts committed to margins. The table below shows how using Nadex is beneficial.
Day trading EUR/USD (Equalized Size 125,000) as well as other instruments requires considerable capital to fund an account, high margin requirements and leverage varies. The chart above allows you a comparison across multiple trading platforms.
The significant advantage of Nadex is reduced capital risked, a huge leverage advantage and you cannot be stopped out in a trade. Remember that because Nadex risk is capped, you cannot lose more than you put up in margin as that amount of cash you risk is your margin.
Nadex is an exchange and is regulated by the CFTC (Commodity Futures Trading Commission.)
If you need to review how spread trading works, please read Spread Basics.
Since you will need to use Nadex to employ the Ultimate Hedge Strategy, it is important to know that Nadex offers binary options and spreads on the following markets:
The Ultimate Hedge Strategy
In our example from above, $650 was lost because of being stopped out on a market spike before the market continued downward. Now let’s look at the same trade using an 8-hour Nadex spread:
A Nadex spread was available with a ceiling of 1.5700 and a floor of 1.5400 (250 pips.) If you sell 10 contracts at 1.5665, then your maximum risk, and margin, is 35 pips or $350.
In the original example, the risk was $650 and the margin requirement was $3,138. In the Nadex spread example shown above, you were not stopped out and you were able to take a profit of $760 within eight hours.
This example fulfills the three rules set forth earlier in the article:
- Less money was risked
- Better leverage
- More time to be right
Here is a comparison of trading a forex spot trade and making the same trade with Nadex spreads:
Now think what would happen to the original Spot Forex trade, presented at the first of this article, if you went short and hedged it with a Nadex spread instead of a stop/loss.
Look at the image below:
A Nadex spread is available with a floor of 1.6700 and a ceiling of 1.5950 (250 pips.) You buy the spread at 1.5710, which becomes your margin risking $100 instead of $650.
When the market spiked, you had a 240 pip Nadex insurance policy protecting your trade. The market continues downward to your profit target.
Your gross profit is $960, less your $100 Nadex spread loss for a net profit of $860.
If you trade Forex or futures, you can trade the way you normally do, but use Nadex spreads to minimize your risk.
Visit www.apexinvesting.com for other ways to further your trading education.
Other articles in this series include:
- Strategies That Risk Less Than $100 -- Introduction To A Series
- Spread Basics
- ITM, ATM, OTM: Some Basic Trading Terminology
- Using Butterflies On 20-Minute Binary Options
- Using The Strangle Strategy On 20-Minute Binary Options
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.
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