Derivative trading is a form of financial trading that involves using contracts that derive their value from an underlying asset, such as a stock, commodity, currency, or interest rate. Derivatives can be used for various purposes, such as hedging against price fluctuations, speculating on future price movements, gaining exposure to different markets or assets, or managing risk.
There are several types of derivative products that traders can use, with each of them having significant differences in their details, risks and benefits. Some of the most popular types of derivatives are spread betting, CFDs, forwards, futures and options. In this article, we will focus on options trading and explore some of the best strategies that can help traders succeed in this market.
1. Straddle
A straddle is a neutral strategy that involves buying or selling both a call and a put option with the same strike price and expiration date on the same underlying asset. A long straddle involves buying both options, while a short straddle involves selling both options.
A straddle is when you buy or sell both a call and a put option with the same price and date on the same asset. A call option lets you buy the asset, while a put option lets you sell it.
- Use a long straddle when you expect a big price change in any direction. You pay a premium to buy both options, and you make money if the price moves a lot. Your profit is unlimited, but your loss is limited to the premium.
- Use a short straddle when you expect no price change. You collect a premium to sell both options, and you keep it if the price stays the same. Your profit is limited to the premium, but your loss is unlimited.
2. Covered Call
A covered call is a bullish strategy that involves owning or buying an underlying asset and selling or writing a call option on it. The trader receives a premium for selling the call option and hopes that the price of the underlying asset will rise or stay below the strike price of the call option until expiration.
A covered call is when you own or buy an asset and sell a call option on it. You get a premium for selling the option and hope that the price will go up or stay below the option price until it expires.
- Use a covered call when you are bullish on an asset but not too much. You earn income from the premium and hedge against a small price drop. Your profit is the premium plus the price difference of the asset. Your loss is the price difference of the asset minus zero.
3. Bull Spread
A bull spread is a bullish trading strategy that involves buying and selling options with different strike prices but with the same expiration date on the same underlying asset. A bull spread can be constructed using either call options or put options.
A bull spread is when you buy and sell options with different prices but with the same date on the same asset. You can use either call or put options.
- Use a bull call spread when you expect a moderate price increase. You pay a net debit to buy a lower-priced call and sell a higher-priced call. You limit your risk and cost, but also your profit.
- Use a bull put spread when you expect a moderate price increase or no change. You get a net credit to sell a higher-priced put and buy a lower-priced put. You collect income and limit your downside, but also your profit.
4. Bear Spread
A bear spread is a bearish strategy that involves buying and selling options with different strike prices but with the same expiration date on the same underlying asset. A bear spread can be constructed using either call options or put options.
A bear spread is when you buy and sell options with different prices but with the same date on the same asset. You can use either call or put options.
- Use a bear call spread when you expect a moderate price decrease or no change. You get a net credit to sell a lower-priced call and buy a higher-priced call. You collect income and limit your upside, but also your loss.
- Use a bear put spread when you expect a moderate price decrease. You pay a net debit to buy a higher-priced put and sell a lower-priced put. You limit your risk and cost, but also your profit.
5. Butterfly Spread
A butterfly spread is a neutral strategy that involves buying and selling options with three different strike prices but with the same expiration date on the same underlying asset.
A butterfly spread is when you buy and sell options with three different prices but with the same date on the same asset. You can use either call or put options.
- Use a long butterfly spread when you expect a narrow price range around the middle price. You pay a net debit to buy a lower-priced option, sell two middle-priced options, and buy a higher-priced option. You limit your risk and cost, but also your profit.
- Use a short butterfly spread when you expect a large price change in any direction. You get a net credit to sell a lower-priced option, buy two middle-priced options, and sell a higher-priced option. You collect income and keep it if the price stays near the middle price. Your profit is limited to the net credit, but your loss is large if the price moves far away.
Conclusion
Derivative trading is using contracts that depend on an asset’s value. Options are derivatives that let you buy or sell an asset at a fixed price and date. Options trading can be very rewarding, but also very risky, so you need to know the best strategies to use.
There are many other ways to trade like hedging, using chart patterns and indicators. These strategies are just a part of the larger trading ecosystem.
Some of the best options strategies are straddle, covered call, bull spread, bear spread, and butterfly spread.
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