Derivative trading is a popular financial instrument in today’s market. Derivatives derive their value from an underlying security such as stocks, commodities, currencies, indices, rate of interest, or exchange rates. Profit is obtained by betting on the future value of the underlying asset.
The two most common types of derivatives traded are futures and options.
Understanding options trading
An option provides the buyer a right to buy at a specified date or price. The key aspect here is that there is no obligation associated with buying at the specified date or price. The underlying security may be bought in exchange for a non-refundable upfront deposit.
There are two kinds of options—’calls’ and ‘puts.’ The right to purchase a security is known as a call option, while the right to sell it is known as a put option. This means that in a call option, the buyer has the right but no obligation to purchase a given quantity of the security at a specified price on or before a future date. The put option, on the other hand, gives the buyer the right but no obligation to sell a given quantity of the security at a specified price on or before a future date.
Strategies to trade in options
Generally, beginners in the options market are not aware of the strategies available to increase returns and minimize risks. This may result in high losses. The following are a few strategies to avoid risk while trading in options.
- Married put
This strategy is used by those who seek to protect themselves against short-term losses. In the married put strategy, investors who purchase an asset, simultaneously purchase a put option for the same number of shares.
- Bull call spread
This options trading strategy is used by investors expecting a moderate increase in the price of the asset. In bull call spread, a call option at a specific strike price is bought, while the exact number of calls is simultaneously sold at a greater strike price.
- Covered call
Investors who make an outright purchase of assets and simultaneously sell a call option on the same assets deploy a covered call strategy. Traders who use this strategy try to protect themselves against a potential fall in the value of the asset, or to obtain greater profits.
Besides the aforementioned strategies, some others include bear put spread, butterfly spread, protective collar, and long straddle, among many more.
About futures trading
Futures trading is an agreement between two parties to buy or sell the underlying security in the future at a specified price. Parties buy stocks at a lower price in the cash market and sell at a higher price in the futures market or vice versa. They, therefore, take advantage of the price difference between the two markets to make profits. In futures trading, both the buyer and the seller have an obligation to execute the contract at a fixed date.
The most common futures contracts are traded on assets such as indices, stocks, currency rates, and commodities, besides others. Trading in futures has a host of benefits. It allows speculators to trade by paying a small margin. Besides, hedgers enjoy the advantage of shifting risk to speculators.
Strategies to trade in futures
Having thorough knowledge on the various futures trading strategies help traders to succeed. While some traders resort to fundamental methods, some use technical analysis, volume profile, or a blend of numerous methods. Following are three strategies used by successful traders.
- Stop-loss order
A stop-loss order, to a great extent, helps in minimizing risk. It is an offsetting order to liquidate the asset at a certain price determined by the trader. The asset then gets converted to a market order for a sale, in case the price of the asset falls.
- Going long
Going long is a strategy used by traders to make profits from an anticipated rise of the asset’s price in the future. The trader enters an agreement to buy and receive delivery of the asset at a set price.
- Going short
When the price of the commodity is expected to decrease in the future, it is advisable to use the going short strategy. In this case, the trader enters into a futures contract by agreeing to sell and deliver the asset at a set price. If the underlying commodity is sold at a high price currently, the contract may be purchased at a lower price in the future, thereby generating profits.
Options trading vs. futures trading: Making the best choice
Whether to trade on options or futures depends on the investment goals and the risk appetite of the trader. The key difference between futures and options is an obligation. Due to the lack of obligation to exercise the contract, options is less risky as compared to trading in futures. Hence, those seeking a conservative approach in their trading methods generally opt to trade in options.
In order to gain maximum profits and minimize risk, it is imperative to gain comprehensive knowledge about the two types of derivative trading as well as their strategies before trying a hand in any of them.