The Risk/Reward Properties of Bull Spreads

The Risk/Reward Properties of Bull Spreads

ThE RiSk/REWaRD PRoPERTiES of BUll SPREaDS Bull Spreads are versatile instruments. They can be used to trade direction, to trade volatility or, in conjunction with conventional products, as a short term risk-mitigation tool. In all these uses, the key Bull Spread advantages apply a low amount of collateral is typically required, and your risk is strictly capped without the danger of you being stopped out by a temporary adverse move. This means it is often possible to use Bull Spreads to enhance your Return on Risk and Return on Capital Employed over a short term trading horizon. In this document we will compare the risk/reward properties of Bull Spreads with the risk/reward properties of trading the underlying, where risk is managed in the underlying by the use of a stop order. an EXamPlE network of BUll SPREaDS: SPoT The chart below shows a typical pattern of Bull Spread contracts on the spot rate. For, contracts are available with tenors of one day, 8 hours and 2 hours (overlapping each hour). This means there are 10 potential contracts available at any given time. The contracts are created throughout the day, centered on where the underlying is at the time of creation, so there are almost always contracts with fl oors and ceilings close to the latest level of the underlying. The chart below shows the fl oor and ceiling levels for 7 of the contracts available on at 7am ET on a hypothetical day (we ve left out the 6am-8am set of contracts, for clarity). 14300 14280 Daily Ceiling 7am-3pm Ceiling 14155 14120 14070 14030 13970 7am-9am Ceiling 7am-9am Ceiling 7am-3pm Ceiling 7am-3pm Ceiling 7am-9am Ceiling 7am-9am Floor 7am-3pm Floor 10am 11am 12pm 1pm 2pm 7am-9am Floor 3pm 13905 7am-9am Floor 7am-3pm Floor 13780 7am-3pm Floor 13700 Daily Floor Zooming in Zooming in, we can see which contracts might be of interest to a spot trader. If the trader has a view that is small scale and short term, (that is, he/she is expecting a trade duration of less than a couple of hours with a profi t target of less than 100 pips), the 7am-9am contracts (in lighter blue, here) may offer the most attractive trading opportunities. If the trader has a view going out to the end of the trading day (3pm ET), or is targeting a bigger market move, then the wider 7am-3pm Bull Spreads (in darker blue, here) may be the most appropriate. 14155 7am -3pm Ceiling 14120 7am -9am Ceiling 14070 7am -9am Ceiling 14030 7am -9am Ceiling 7am -9am Floor 5am 6am 7am 8am 7am -3pm Ceiling 7am -3pm Floor 9am 13970 7am -9am Floor 7am -9am Floor 13905 7am -3pm Floor Futures, options, and swaps trading involves risk and may not be appropriate for all investors. Any trading decisions that you may make are solely your responsibility. The information presented herein is for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular fi nancial instrument offered on Nadex. Past performance is not necessarily indicative of future results. The Risk/Reward Properties of Bull Spreads, June 2013 Page 2 of 9

7am-9am contracts Let s assume we have a very short term trading horizon, and focus on the 7am-9am contracts. There are three. The highest, shown in red here, has a Floor roughly where the current market is, and a Ceiling 100 points higher. It is priced around 10 pips higher than the spot rate. This is because any buyers of the contract would gain the benefit of a nearby Floor that would cap their risk but never stop them out. The lowest, shown in blue here, has a Ceiling roughly where the current market is. It is priced around 7 pips lower than the spot rate. This is because any sellers of the contract would gain the benefit of the nearby Ceiling that would cap their risk but never stop them out. The middle contract, shown in green here, is centered on the current spot rate and trades almost exactly at that rate it has no nearby Floor or Ceiling to introduce optionality into its price. Note that these prices assume average volatility for and that no major announcements are expected. If, for example, Nonfarm Payrolls were about to be announced at 8.30am, it is likely that Nadex participants would place a higher value on the protection offered by Bull Spread Floors and Ceilings. In that scenario it is likely that the top and bottom contracts would trade further from the spot rate than the 7-10 pips seen here. 14120 7am -9am -14120 14070 trading at 14017 7am -9am 13970-14070 7am -9am -14120 13970 7am -9am 13970-14070 Contract Bid Size Bid Offer Offer Size EUR/USD -14120 (9am) 50 14026 14028 60 Bull Spread trades above spot rate when spot rate is close to floor EUR/USD 13970-14070 (9am) 55 14016 14018 40 Bull Spread trades at or close to spot rate in middle of range EUR/USD - (9am) 35 14009 14011 45 Bull Spread trades below spot rate when spot rate is close to ceiling The Risk/Reward Properties of Bull Spreads, June 2013 Page 3 of 9

EUR/USD - (9am) Now let s assume we have a view that the, having met resistance, is about to start tracking downwards. One way to trade this move in a limited risk way would be to sell the spot at 14017 and place a stop at some key level like, say, 14050. This caps risk at 33 pips in most cases (although if the market makes a surprise jump upward, gapping through our stop level, the biggest potential loss could be worse, possibly much worse, than this). Another way to take this view is to short the - Bull Spread, shown here in blue. The risk here would be capped at just 11 pips in all circumstances the Bull Spread cannot settle, or be priced, any higher than its Ceiling level of at any point, regardless of gapping in the market. And the risk cap here has the quality of an option; in other words, the underlying market may temporarily go through the level of the Ceiling without stopping out our position we could still profit if we re proven right later on in the life of the contract. The price for this is that we are selling 8 pips below the spot rate and we are accepting a cap on our highest possible profit just as the contract cannot settle above, neither can it settle below. So we are risking an absolute worst case loss of 11 pips to make a profit that can never be higher than 89 pips. trading at 14017 Bull Spread bid at 14009 Maximum risk: 11 pips Maximum profit: 89 pips Contract Bid Size Bid Offer Offer Size EUR/USD -14120 (9am) 50 14026 14028 60 EUR/USD 13970-14070 (9am) 55 14016 14018 40 EUR/USD - (9am) 35 14009 14011 45 The Risk/Reward Properties of Bull Spreads, June 2013 Page 4 of 9

Scenario 1: We are wrong in our view Now let s roll the clock forward in a hypothetical world where we were wrong about the. In this world, the travels thorough the 14050 stop level at 8.05am; had we been short the spot with a stop at 14050 we would have seen our position close at this point for a loss of 33 pips. Our Bull Spread would remain live until expiration at 9am, when it would settle at a value of ; a loss to us of only 11 pips. entry level at 14017 Stop at 14050 trade stopped out at 8.05am at 14050, for a loss of 33 pips Bull Spread entry level at 14009 7am-9am - Bull Spread expires at 9am at, for a loss of 11 pips Here s what this would look like in terms of P&L. These numbers have assumed we have traded in the same $-per-pip size in each case: 1 standard lot (E100,000) of, or 10 lots of the Nadex Bull Spread. In either case, our exposure per pip (of spot ) or per point (of the Bull Spread) would be $10. We can see that the Bull Spread strategy cost us only one third of the losses we would have experienced trading the spot with a 33 pip stop. We can also see that the Bull Spread strategy required only about 4% of the capital required to establish the spot position, assuming spot FX is margined at 2% ($110 vs. $2803.40). This has the effect of hugely magnifying our (negative) Return on Capital, from -12% to -100%. But, in absolute dollar terms, we only lost one third as much. FX margin required (1 standard lot) $2,803.40 Bull Spread collateral required (10 lots) $110.00 FX risk (USD, assuming no slippage) $330.00 Bull Spread risk (USD) $110.00 FX P&L (pips) -33 FX P&L (USD) -$330.00 Bull Spread P&L (points) -11 Bull Spread P&L (USD) -$110.00 Return on Capital Employed (spot FX) -12% Return on Capital Employed (Bull Spread) -100% Return on Risk (spot FX, assuming no slippage) -100% Return on Risk (Bull Spread) -100% The Risk/Reward Properties of Bull Spreads, June 2013 Page 5 of 9

Scenario 2: We are immediately correct with our view Now let s look at another scenario. This time, let s assume we were right the is unable to break through resistance around the level and falls back by 70 pips or so over the following 2 hours. This time we take profits when the spot hits 13950. The Bull Spread can also be bought back at 13950 at this point (we are not particularly close to a Floor or Ceiling, and very little time is left until expiration, so the Bull Spread trades at the same price as the spot rate). entry level at 14017 Stop at 14050 Bull Spread entry level at 14009 Bull Spread exit level of 13950, for a profit of 59 pips trade exit level of 13950, for a profit of 67 pips Comparing the numbers, we can see that the Bull Spread strategy has made less than the simple spot trading strategy in absolute dollar terms, because we paid for option-like risk insurance that, in this case, wasn t needed. Again though, we can see the effect of the very low collateral requirements of Bull Spreads at work. Because we only had to put $110 down to establish the Bull Spread position (rather than the $2800 necessary to trade the spot), our return on capital was enormously magnified, coming to 536% rather than 24%. FX margin required (1 standard lot) $2,803.40 Bull Spread collateral required (10 lots) $110.00 FX risk (USD, assuming no slippage) $330.00 Bull Spread risk (USD) $110.00 FX P&L (pips) 67 FX P&L (USD) $670.00 Bull Spread P&L (points) 59 Bull Spread P&L (USD) $590.00 Return on Capital Employed (spot FX) 24% Return on Capital Employed (Bull Spread) 536% Return on Risk (spot FX, assuming no slippage) 203% Return on Risk (Bull Spread) 536% The Risk/Reward Properties of Bull Spreads, June 2013 Page 6 of 9

Scenario 3: We are right, but face an intermediate adverse move This time consider a scenario where the option-like nature of the Bull Spread contract s Ceiling level is at its most valuable. Here our position moves significantly against us before coming good. And in this hypothetical example, the adverse move is enough to trigger the stop on spot, locking in a loss on the spot trade of 33 pips. The Bull Spread position survives, however, and we are able to close it out later at a level of 13950, for a profit of 59 pips. entry level at 14017 Stop at 14050 trade stopped out at 14050, for a loss of 33 pips Bull Spread entry level at 14009 Bull Spread exit level of 13950, for a profit of 59 pips And here are the numbers a huge difference in outcome. This is the kind of result that explains why stop orders are free, but options cost money. Or, to put it another way, why Bull Spread prices diverge from the underlying market level when the underlying is close to the Bull Spread s Floor or Ceiling. This divergence in price is a reflection of optionality in the contracts, and it is only optionality that can control risk without stopping a trader out. FX margin required (1 standard lot) $2,803.40 Bull Spread collateral required (10 lots) $110.00 FX risk (USD, assuming no slippage) $330.00 Bull Spread risk (USD) $110.00 FX P&L (pips) -33 FX P&L (USD) $330.00 Bull Spread P&L (points) 59 Bull Spread P&L (USD) $580.00 Return on Capital Employed (spot FX) -12% Return on Capital Employed (Bull Spread) 536% Return on Risk (spot FX, assuming no slippage) -100% Return on Risk (Bull Spread) 536% The Risk/Reward Properties of Bull Spreads, June 2013 Page 7 of 9

Scenario 4: We catch a major market move perfectly Finally, let s look at the dream scenario where, almost immediately after we go short, the market suffers a significant sell-off, and we let our position run. In this case the Bull Spread bottoms out at its Floor level, expiring at 9am at for a profit of 89 pips. The spot trade, however, has no cap on profits in this example an exit is assumed at 13890, a profit of 127 pips. entry level at 14017 Stop at 14050 Bull Spread entry level at 14009 Bull Spread expires at 9am at, for a profit of 89 pips Exit from spot trade at 8.45am at 13890, for a profit of 127 pips The spot strategy is the clear winner here, in absolute dollar terms, mostly because of the fact that the maximum profit available on our Bull Spread strategy, given our entry level, was 89 pips. However, the Bull Spread is still ahead in terms of return on capital; collateral of just $110 resulted in a profit in this case of $890. The spot trade required 25 times as much capital over $2800 to generate a profit of $1270. FX margin required (1 standard lot) $2,803.40 Bull Spread collateral required (10 lots) $110.00 FX risk (USD, assuming no slippage) $330.00 Bull Spread risk (USD) $110.00 FX P&L (pips) 127 FX P&L (USD) $1,270.00 Bull Spread P&L (points) 89 Bull Spread P&L (USD) $890.00 Return on Capital Employed (spot FX) 45% Return on Capital Employed (Bull Spread) 809% Return on Risk (spot FX, assuming no slippage) 385% Return on Risk (Bull Spread) 809% The Risk/Reward Properties of Bull Spreads, June 2013 Page 8 of 9

Scenarios compared Looking at these scenarios together, we can see a few general patterns. One of the most obvious is that Bull Spreads, when traded in the way described in this presentation, tend to significantly magnify Return on Risk and Return on Capital Required (note that this sometimes applies to negative returns as well as to positive returns). Another is that, for a given $-per-point exposure to the underlying, a Bull Spread strategy will tend to deliver a smaller profit, or a smaller loss, than a trade in the underlying the optionality in the contracts costs a few pips of profit when your trade is successful, but also tends to protect you from some of the downside when you are wrong. Finally, Bull Spreads can deliver a radically better outcome (in comparison to trading the underlying with a stop order in place) in cases where the market eventually moves in your chosen direction, but initially moves against you. This benefit is a result of the contracts in-built optionality it is why optionality costs money, but stop orders are free. Scenario Details Scenario 1 We are flat wrong Scenario 2 We pick a moderate move correctly Scenario 3 We get the move right, but face an adverse move in the interim FX margin required (1 standard lot) $2,803.40 $2,803.40 $2,803.40 $2,803.40 Bull Spread collateral required (10 lots) $110.00 $110.00 $110.00 $110.00 FX risk (USD, assuming no slippage) $330.00 $330.00 $330.00 $330.00 Bull Spread risk (USD) $110.00 $110.00 $110.00 $110.00 FX P&L (pips) -33 67-33 127 FX P&L (USD) -$330.00 $670.00 $330.00 $1,270.00 Bull Spread P&L (points) -11 59 59 89 Bull Spread P&L (USD) -$110.00 $590.00 $580.00 $890.00 Return on Margin (spot FX) -12% 24% -12% 45% Return on Margin (Bull Spread) -100% 536% 536% 809% Return on Risk (spot FX, assuming no slippage) -100% 203% -100% 385% Return on Risk (Bull Spread) -100% 536% 536% 809% Scenario 4 We get the right side of a big market move Summary Bull Spread trading is sometimes a more appropriate choice than trading the underlying, sometimes less. The choice depends on your trading style, risk appetite, trading horizon and immediate outlook on the market. Trading a specific Bull Spread contract may make sense when: (i) You have a short term view (your time horizon ends before the expiration time of the contract in question). (ii) You want the protection of strictly capped exposure without the risk of getting stopped out by short term adverse moves (i.e. you foresee short term volatility/whipsawing in the market). (iii) Your intended take-profit level lies within the Floor-Ceiling range of the contract in question (Bull Spreads can cap profits as well as losses not a desirable effect if you strongly believe the market is about to move a very long way in your favor). (iv) You want to magnify your Return on Capital or Return on Risk. Selling a Bull Spread near its Ceiling (or buying a Bull Spread near its Floor) will tend to have this effect in most scenarios. But remember this is a double-edged sword. Negative returns are magnified, just as positive ones are. Range of Markets We offer Bull Spread contracts on: Equity Indices: US 500, Wall Street 30, US Tech 100, US SmallCap 2000, Germany 30, Japan 225, FTSE 100 FX: EUR/USD, USD/JPY, GBP/USD, USD/CHF, USD/CAD, AUD/USD, EUR/JPY, GBP/JPY Energies: Crude Oil, Natural Gas Metals: Gold, Silver, Copper Agriculturals: Corn, Soybeans Futures, options, and swaps trading involves risk and may not be appropriate for all investors. Any trading decisions that you may make are solely your responsibility. The information presented herein is for informational purposes only. The contents hereof are not an offer, or a solicitation of an offer, to buy or sell any particular financial instrument offered on Nadex. North American Derivatives Exchange, Inc. 311 South Wacker Drive Suite 2675 Chicago, IL 60606 Phone: 312-884-0100 Fax: 312-884-0940 Email: customerservices@nadex.com www.nadex.com The Risk/Reward Properties of Bull Spreads, June 2013 Page 9 of 9