Derivative Strategies are the way of using products like future, option, or a combination of them depending on the direction of the market or the individual stock. While formulating the strategy, the investor should keep in mind the factors like objective, the volatility of the underlying, viewpoint of the direction, and risk capacity. Some of the investors also utilize already available technical indicators like open interest, turnover, put-call ratio option premium, etc.
Before diving into the several trading strategies, it''''''''s important to note that futures and options are poles apart products. The following section deals with the future as well as options strategies in detail.
Future Trading Strategies
The strategies depend on the trader’s objective like hedging, speculation, and arbitrage. The majority of future traders are speculators and hedgers. The hedger interest only lies in protecting themselves from the price risk in the underlying asset. While the speculators are the risk-takers earning a handsome return from the prices to move in their expected direction.
- Long Futures: When the buyer agrees to purchase the underlying asset.
- Short Futures: When the seller agrees to sell the underlying asset.
Options Trading Strategies
Unlike stocks, the option is a difficult product to trade, which comprises of two types: call and put. To make profit yielding strategies both of these can be bought or sold or even combine to make advanced strategies.
- Depending on which Right to Buy
· Call Option: The option provides the right but not the obligation to the holder to buy the underlying asset at the fixed price by paying the premium. This is bought by those traders who are bullish on the asset and pay a small amount to maximize their returns.
· Put Option: The option provides the right but not the obligation to the holder to sell the underlying asset at the fixed price by paying the premiums. These are bought by those who have a bearish view on the asset.
Now comes the interesting section in which we explore several options strategies to deploy in the market for hedging and speculation.
- Hedging against a price increase or Speculation
· Long Calls: This is the simplest hedging strategy that is used to protect the losses of a trader short in cash or futures by simply buying a naked call option. For speculators, when the underlying prices increase beyond the strike price, they gain a huge return on their investment. However, the loss is restricted to the premium.
· Short Put: The premium is received by selling the put option which will offset the price increase in the cash market. If the stock keeps on falling, the put option can be exercised against him leading to losses.
- Hedging against Price decline or Speculation
· Long Put: This is used by the traders long on the cash or futures product by simply buying the put option. If the stock tends to fall, this will be compensated by exercising the put. In the case of speculation, the bearish direction can be leveraged with buying a put. In this case, as well, the loss is restricted to the premium only.
· Sell Calls: This is another way to protect investors against a small price decline. The premium received will compensate for the falling market losses.
- Option Spread Trading
· Straddles: These are used by speculators who believe that the prices of underlying will move in one direction or trade in a range. This is formulated by simultaneously buying and selling options.
· Long Straddles: A long straddle is created by buying an equal number of calls and puts with the same strike price and with the same expiration date. This way, an investor can earn from one-way full direction movement of the stock.
· Short Straddles: The investor sells an equal number of calls and puts for the same strike price and with the same expiration date. This is reverse than long straddle and works in a range-bound market.
· Strangles: This strategy is the same as straddles but only with a different expiration month.
· Long Strangle: With this strategy, a trader can make money if the stock trades outside the range of lower and higher strike prices. This is done by long put lower strike price and long call higher strike price.
· Short Strangle: The investor can make money only if the market is expected to trade between a range defined by strike prices. This is done by short put lower strike price and short call higher strike price.
· Verticle Spreads:
· Verticle Bull Spreads: If a trader expects the market to go up but with a limited potential then this will be the best bet. This involves Long call Lower Strike, short call Higher Strike Long put Lower Strike, short put Higher Strike.
· Verticle Bear Spreads: If a trader expects the market to go down but with a limited potential then this will be the best bet. This involves Short put lower strike price, long put higher strike price, and Short call lower strike price, long call higher strike price.