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Derivatives Trading Strategies
Derivatives trading is the trading of contracts or financial instruments that are derived from assets that are traditionally traded (such as stocks). The trading of these derived contracts are more sophisticated and advanced, and are generally not recommended for first-time investors (we will get into the reason for this later on).
The most common derivatives available (based on what your country's stock exchange board offers) are options and futures. They are normally regulated by exchange boards, such as the Chicago Board Options Exchange (CBOE) pictured above. In brief, options and futures contracts give you the right to buy (or sell) the underlying assets at a future date at a pre-determined price. The number of investment options based on this derived concept is huge. However, we won't be getting into detail here. If you want to learn more, you are welcome to read our literature on trading.
The reasons for trading derivatives depend on your investment strategy and what you wish to gain by trading them. Common reasons include:
- Hedging - If you have bought the stock of a company but are worried that the stock price might go down, you could hedge that investment by using one of a few option strategies to limit your losses. These options contracts act like insurance in case the stock price actually falls.
- Speculation - The price for options contracts are lower than the price of the underlying stock itself, and also give a higher return on investment. If you predict a stock to jump in price, you could buy options contracts for that stock instead and see a much larger percentage profit. However, the risk of loss is much higher as well if the stock goes the wrong way.
Things to consider if you are interested in derivatives trading:
- Derivatives are very high leverage compared to the underlying stock. Your money goes further and sees bigger returns if you traded in the right direction. Conversely, your losses are also much bigger if you went the wrong way. It is very possible to lose nearly all your investment with a wrong trade in derivatives.
- Derivatives have a target date or used-by date, and will expire worthless on that date. It is good for investors whose strategies involve short-term trades, but is not suitable for investors who prefer the "buy-and-hold" method of trading. In either case, if your underlying stock does not move in the way you hope as this expiration date approaches, your risk of losing on your trade starts to grow.
- When you purchase a derivatives contract, it is important to note that you do not actually own any stock or asset. All you own is the right to buy or sell that underlying asset.
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