Common derivatives such as options, futures, and forward contracts are widely used by traders for both hedging against risks and predicting market movements. These traders employ a variety of strategies, including range trading, covered calls, protective puts, and others, to accomplish their financial goals.
Let us understand some popular derivative strategies in detail.
What are derivative trading strategies?
First, let us understand the meaning of derivatives. Derivatives are financial instruments, such as options, futures, swaps, and forwards. They derive their value from the performance of an underlying asset, index, or interest rate.
For example,
- The value of a futures contract is directly linked to the price of corn in the market.
- If the price of corn increases, the value of the futures contract also increases, and vice versa.
Now, coming to derivative strategies, these refer to the use of financial instruments to:
- Anticipating the price movements of the underlying asset without directly owning it
- Hedge against adverse price fluctuations, and
- Perform arbitrage by exploiting price differentials
There are several common derivative trading strategies, each with its own goals and risk profiles. Let us understand them in detail.
Popular derivative trading strategies
| Derivative strategies | Meaning | Example |
| Hedging | This strategy involves using derivatives to offset potential losses in an underlying asset. |
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| Arbitrage | Arbitrage strategies seek to profit from pricing inefficiencies between the derivative instrument and its underlying asset. |
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| Spread trading | Spread trading involves simultaneously buying and selling two related instruments, such as options or futures contracts, to profit from the difference in their prices. |
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What are futures trading strategies
Futures trading involves buying or selling standardised contracts related to an underlying asset at a predetermined price and date in the future. These standardised contracts are traded on organised exchanges and are available for a wide range of assets, including:
- Commodities
- Stocks, and
- Indices
Popular futures trading strategies
- Trend following
- This strategy involves identifying and following trends in futures prices.
- Traders aim to enter positions in the direction of the prevailing trend.
- They buy futures contracts in uptrends and sell or short contracts in downtrends.
- Range trading
- Range trading involves identifying periods of:
- Price consolidation or
- Range-bound movement
- Traders aim to buy near support levels and sell near resistance levels
- This way, they can profit from price movements within the established range
- Range trading involves identifying periods of:
- Spread trading
- Spread trading involves simultaneously buying and selling related futures contracts to profit from price differentials between them
- Common spread trading strategies include:
- Calendar spreads, where contracts with different expiration dates are traded
- Inter-market spreads, where contracts for related but different assets are traded
Tips for optimising trades
| Perform technical analysis | Choose an appropriate position size |
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What are options trading strategies?
Options trading involves the buying and selling of contracts that give the holder the right, but not the obligation:
- To buy (call option) or
- Sell (put option)
- An underlying asset
- At a specified price (strike price)
- Within a predetermined period (expiration date)
Options are versatile financial instruments popularly used for:
- Hedging
- Income generation, and
- Risk management
Popular options trading strategies
- Long call
- This strategy involves buying call options.
- The expectation is that the price of the underlying asset will rise significantly before expiration.
- Long-call options offer unlimited profit potential.
- At the same time, these limit the trader's risk to the premium paid for the options.
- Long put
- The long put strategy involves buying put options.
- The expectation is that the price of the underlying asset will decline significantly before expiration.
- Long put options allow traders to profit from downward price movements.
- At the same, the trader’s risk is limited to the premium paid.
- Covered call
- In this strategy, traders who own the underlying asset sell call options against it.
- This strategy generates income through the premiums received from selling the call options.
- Protective put
- The protective put strategy involves buying put options.
- It allows traders to hedge against potential losses in an existing long position.
- It also provides downside protection by allowing the holder to sell the asset at the strike price.
- Straddle
- In this strategy, a call option and a put option are purchased.
- Both of them have the same strike price and expiration date.
- Traders use this strategy when:
- Significant price volatility is anticipated, but
- There is uncertainty about the direction of the price movement
- The straddle profits from large price movements in either direction.
Tips for optimising trades
| Diversify | Use stop-loss Orders |
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Conclusion
Derivative trading strategies allow traders to manage risk, anticipate price movements, and capitalise on market inefficiencies. This is done using various derivative instruments, such as options and futures and popular trading strategies like hedging, arbitrage, spread trading, and many more.
However, to make informed trading decisions, it is necessary to perform technical analysis, spread risk via diversification, and adopt appropriate risk management strategies.
