The Differences between Master and Narrow Spreads – Financial Derivatives
A key benefit of financial derivatives trading is the range of markets that are available to trade, often via one sophisticated online trading platform.
Whether it is OTC or through an exchange such as Nadex, markets range from the familiar, like commodity and forex trading, to the new and innovative binary options.
This article will help you better understand the nature of the spread contracts offered.
Master Spreads
The Master Spread is a one-day, variable payout contract with lower (“Floor”) and upper (“Ceiling”) strikes. These strikes are set at relatively wide intervals from the underlying market level at the time the contract is listed .
The pricing of the Master Spread tends to reflect the underlying futures market or spot FX pricing. The Master Spread is a derivative contract and, like a wide vertical call Spread, it has a direct correlation to the underlying market. Because of this, Master Spreads tend to reflect the underlying price when it is trading well within the range defined by the Master Spread.
So, as the price of the underlying market moves toward the floor or Ceiling set by the Master Spread, the price correlation decreases typically.
Although the Master Spread’s price levels can follow the underlying asset’s price levels, unlike the underlying product, the Master Spread’s minimum tick value is only $1.00 and a Master Spread contract can require substantially less capital than the initial margin required for a single underlying futures contract.
The Master Spread’s capital requirement is the dollar value between (a) the buyer’s initial price level and the contract’s Floor or (b) the seller’s initial price level and the contract’s Ceiling. The Floor and Ceiling levels of the Master Spread act as a collar to the trading range. The market pricing of the Master Spread will never be quoted outside of the trading range of the Floor and Ceiling price levels.
The actual underlying market may at times have market swings that move outside of this range but your risk exposure is always limited to the range between these two prices. In this manner, the Floor and Ceilings act as limiting your potential exposure against adverse market movements but also limit your ability to maximize your potential profit in positive market movements.
Variable Payouts, where the value at expiry lies between the Ceiling and Floor levels, is a fundamental feature of all Spread contracts. This differs from the “All or Nothing” payout of a Binary Contract. If the expiry value is less than or equal to the Floor (for the seller) or greater than or equal to the Ceiling (for the buyer) then the maximum payout is earned.
NARROW SPREADS
In addition to the Master Spread, Nadex also offers several Narrow Spread contracts. Like the Master Spread, the Narrow Spreads have lower and upper strikes, known as the Ceiling and the Floor. The range between the Ceiling and the Floor, is the basic difference between Master and Narrow Spreads, with Narrow Spreads covering a smaller range. Because the range is smaller, the contract value is less than the Master Spread, thus creating less risk of loss but also less profit potential.
Narrow Spread contracts—just like Master Spreads, are never quoted outside of the Ceiling and Floor range pre-established. This holds true even if the underlying market is trading outside the range. Also like the Master Spread, positions in the Narrow Spread may be closed in the market prior to expiration or held until expiration.
Additionally, the Narrow Spread’s tighter Ceiling and Floor levels means that the underlying market will often trade near (or outside) these levels. The Narrow Spreads typically reflect more optionality in their pricing than Master Spreads . This pricing is more reflective of a typical option call Spread, rather than a future. Therefore, the Narrow Spreads do not show as much correlation to the underlying market as the Master Spread.
Narrow Spreads, therefore, are more reflective of optionality than Master Spreads’ pricing, but still reflect the risk/reward of that contract.
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