Trade Brexit With Defined Capped Risk

This is second in a series explaining Brexit and how to trade this UK referendum on whether the country will leave the European Union.

Polls will close in the UK at 10 p.m. on Thursday to decide whether the UK should leave the European Union. Votes will start to trickle in just after midnight, and final results are due about 2:00 a.m. ET Friday. This week is an opportunity to get familiar with trading Nadex spreads during high volatility times and see how implied volatility affects the markets.

The advantage to trading Nadex is the defined capped risk, unlike spot forex markets which have unlimited risk and, for this event, likely margin calls. Spreads should be easier to trade as they are not an all or nothing option like binaries.

Binaries will be challenging to trade, as a binary is a reflection of a probability. The polls show the vote is close, and either decision will have a massive impact on currencies. Markets will react, and moves as great as 500 pips or 1000 pips or even multiple moves can be expected. All of this implied volatility, which is expected movement built into pricing, means binaries will be expensive, with a higher probability of strikes being In The Money (ITM). This puts all binary strikes at a 50/50 probability way up and down the price ladder, making them At The Money (ATM) and closer to ITM. Prices are going to be closer to center, around $50, showing the 50/50 probability and anything can happen.

Nadex opens for trading at 6:00 p.m. ET, one and one half hours before results begin coming out. If a trader believes the market will pop or move all over the place and land flat, then a neutral strategy to collect premium should be used. If one thinks the market is going to blow up and really fly, then a breakout spread straddle can be traded, which is a paying premium strategy. Moves can also be traded directionally using Nadex spreads, but should be done quickly.

The Nadex EUR/GBP spread has the currencies that will be playing off one another. Other Nadex spreads including currencies directly affected are GBP/USD, GBP/JPY, EUR/JPY, and EUR/USD. If the UK were to leave the EU, it wouldn’t be overnight. It would more be an unraveling from the EU over a two-year period. However, the currency market will start reflecting what that means; it will affect the UK bonds, corporate bonds, FX, everything.

Trading Nadex spreads can begin as early as Sunday evening, for Monday’s London session open, when the big moves in the currency markets will begin to be seen around 3:00 a.m. ET. Around 6:00 a.m. ET, the markets will begin to calm down and flatten out a bit until the New York session opens and another big move can happen. This cycle could continue throughout the week with it culminating through Friday evening.

Trading directionally using spreads, one should choose a Near The Market spread with low-to-no proximity, and do so quickly as the markets could move  unpredictably. 

If premium is high, then an Iron Condor can be used. A lower spread is bought and an upper spread is sold, where the ceiling of the bought spread meets the floor of the sold spread, and is where the market is trading. Try for as much profit potential as possible, with it split as evenly as possible between the spreads. With this setup, to easily determine where to place stops at a 1:1 risk/reward ratio, simply double the profit potential number. That will be the number of pips above and below to place the stops. Should the market pull back close to between the spreads, the trade will gain premium as time expires and gets closer to settlement.

If premium is lower, a breakout Straddle strategy can be used. This is the exact opposite of an Iron Condor. The upper spread is bought and the lower spread is sold, with the ceiling of the sold spread meeting the floor of the upper spread and where the market is trading at the time. Risk should be as low as possible, and dispersed as equally as possible between the spreads. This is the strategy to use when it’s expected the market will take off and fly. To determine where to take profit, simply double the total risk. That number will be the number of pips above and below to exit for a take profit, with a 1:1 risk/reward ratio thus covering the loss of the other side. Should the market hit the take profit on one side, leave the other side on. The market could pull back and the other spread may not have as great a loss and possibly make some profit. With this strategy, stops aren’t usually necessary, as the risk is low.

The real advantage to these strategy opportunities trading Brexit is Nadex having defined capped risk. The total risk is known and paid up front, and can be further managed with stops when necessary, making risk realistic.