By Darrell Martin
The Box Spread was introduced in part one of this series. To read part one, click HERE.
It explained the problems associated with trading when the trade spikes against you, also known as Whipsaw. It briefly touched on margin, leverage and profit potential.
In part two, an example will be presented that will help you better understand how the Box Spreads work. It will compare the difference in trading full Futures contracts, E-mini contracts with Nadex Spreads.
A Quick Scenario:
(Note, bid/ask, commission, slippage and exchange fees are not factored into risk/reward calculations as they may vary based on broker, memberships, fills and volume. In addition, this allows for simplicity of the illustration for education purposes.)
You wanted to take advantage of movement after the US Unemployment Rate and Non-Farm Payroll report was released. The number was much worse than expected. The market spiked down, did a pull back and you believe the market is ready to resume its downward trend. So which instrument will you use to attempt to take advantage of this downward move?
The Entry! Will you use ETF’s, Futures, Options or Box Spreads?
You short one S&P 500 Futures contract at 2034.00. You believe in good risk management, so you set a stop above the recent high before the report at 2038. Since you are risking four points (2038-2034) your total risk is $200 ($50 x 4 points x 1 contract.) If your 2038 stop loss is hit, you will be stopped out and will lose $200. You will then have to choose to put additional money at risk in order to re-enter the trade. Plus, if your stop is ran through, you could end up losing much more than $200. This already sounds painful!
To place a trade, you have to put up margin which is money on hold to cover risk so that the broker does not get stuck with your losses. To place this trade on the S&P 500 E-mini Futures contract, you would have to put up between $400 and $4375 depending on who you use as a futures broker. At a margin rate of $400 per contract, this would give you a maximum leverage of 173.5:1 ($69,200 x 400.) This is far less leverage than the Box Spread. If you have to put up more margin or drawdown, this will also decrease your leverage.
You considered placing a trade of similar value and profit potential on the SPDR S&P 500 ETF (SPY.) After checking into this, you found that you would need approximately $17,300 of margin for day trading or double that, $34,600 for a Reg-T Margin Account. In addition, you may still have to put up additional capital when or if the trade moves against you. With day trading, this gives you a leverage of 4:1 and could also cost you interest on the margin being used if the cash is not in your account. This depends on your broker agreement and how long your hold the trade. You decide the leverage is not worth your money’s time, so you do not go the ETF route.
You also looked at doing an S&P 500 E-mini put option trade that was a few dollars in the money: 2033 strike, which expired on the same Friday as the entry for the S&P Futures. It would cost you approximately $250 to $450. If you could get it for only $250, that would give you the maximum leverage of 276:1. If you placed this trade on any day other than a Friday, the cost could easily be two times that amount to cover the extra premium (time value) in the put option and would also decrease your leverage. There are other things to consider if you choose to trade a put option, like the five Greeks and so you opt not to go the put option route as it increased your risk over the outright future and is more complex.
The Spike!
Within less than two minutes of placing the trade, the market spikes upwards against you a full five points. If you trade the S&P 500 Futures contract, the spike has hit your four-point stop loss and knocked you out. You have lost $200. You must now make the decision to either buy the future and risk more money, sell the future again and risk more money, or just stop trading for the day accepting the fact that the market spiked you out. Don’t you feel the pain!!
However, if you chose to sell five 2035-2015 Box Spreads, you are down, but you are not out. You have limited your risk to a measly $10 per spread on five spreads for a maximum risk of $50. You wait in anticipation that you are tight and watch to see if the market will fall back.
The Whipsaw!
You were right! The market was going to fall. You pat yourself on the back for being right. However, as an outright E-mini S&P 500 Futures trader, you now have a tough choice to make. It spiked, it knocked you out, what now? It is falling. Do you go short again and risk another whipsaw and risk more money? You either nervously hit the button with sweaty palms or you sit on your hands and watch in anguish as the market moves down 20 points in the direction you picked. You missed out on a $1,000 profit on just one measly futures contract. You tell yourself you were right and next time you won’t set your stops so tight. But you know how that story goes; the next time it just keeps rising. You are overwhelmed and look for the next guru course trying to find better timed entries when the real problem all along was not your entry. It was the risk management method you had because of the instrument you were trading.
The Victory!
Wait a minute…you did not short the future! You shorted five US 500 2035-2015 spreads. You breathe a sigh of relief! The spike did not knock you out. You do not have to risk more and you are still in the trade. The market is falling, falling, falling, and you are riding this puppy all the way down. You let it close out, and it settles near the low of the day. Hah! You knew it was going to fall, and you were smart enough to choose an instrument that limited your risk, eliminated the market’s power to spike against you, and that gave you time to be right. The US 500 settles out at 2019.50. You sold it at 2034. Your profit is 2034-2019.5 for a profit of 14.5 points, 145 ticks (14.5 /.1 tick), a profit of $145 per spread and a total profit of $725 on a $50 risk/margin trade for a return of investment of over 1450%! Trading just became fun again.
Where can I Trade Box Spreads?
Nadex, The North American Derivative Exchange is the only US exchange designed primarily for retail traders. Nadex offers two products: Bull Spreads, which this article refers to as Box Spreads, and Binaries. It is subject to regulatory oversight by the Commodity Futures Trading Commission. You can demo trade as well as live trade. To learn about all of what Nadex has to offer, visit www.nadex.com.
The Takeaway:
With this new method, you can be down, but that does not mean you are out. You can completely define your risk before you enter the trade. No matter how far the market moves against you, your risk is 100% defined. When your max risk is hit, your trade is not closed and your risk does not increase. This gives you time to be right. It removes the market’s annoying ability to spike against you and whip you out of the market. The sweaty palms and stress of seeing risk increase tick by tick are no longer a challenge for you. Now you can put your focus on the market, picking your entries and managing your profits, because your risk is 100% managed for you by using this simple Box Spread trading strategy.
To learn other strategies and systems to use when trading, go to www.apexinvesting.com. Apex Investing Institute offers free education, and free access to the Nadex Binary and Spread Scanner Analyzers. Member traders are invited to trade in the chat rooms, take advantage of trade signal services, have key indicators and access the Apex Forum. The forum content is updated daily and includes over 9000 members. In a supportive learning community of seasoned as well as up and coming traders, traders of all levels learn how to trade Nadex binaries and spreads in depth, as well as futures, forex, stock and options, and gain an edge for successful trading overall.