Derivative trading is the most complex form of financial investing. The best strategies for derivative trading are high probability trades with good risk to reward ratios. The strategy selected must fit within the parameters of the trading system. These systems are designed with specific objectives, money management rules, and the type of trading to be undertaken.
The retail investor has access to futures and options on various financial assets within the derivatives market. Over-the-counter (OTC) options are not typically traded by retail investors but are available in some countries. Navigating these complex markets and selecting the right strategy at the right time is difficult for even the most experienced traders.
Derivatives are traded for hedging, risk management, and speculative purposes. Futures contracts may be traded for the actual sale and delivery of commodities and other assets. The system and strategy used should fit the purpose of the investment. A strategy developed for risk management may not be appropriate for speculation. Derivative trading strategies are developed for a wide variety of purposes.
Determining the best strategy for speculative purposes would involve a directional bias on the underlying asset. The process of directional analysis can be performed through fundamental or technical techniques. Fundamental analysis is a method of evaluating the price of an asset through qualitative and quantitative studies. Technical analysis is commonly referred to as chart reading, and incorporates a variety of indicators and chart patterns.
Once a directional bias has been determined, the investor can select the appropriate derivative trading strategy. Option strategies provide calls and puts which can be bought or sold. Bullish, bearish, and neutral strategies can be implemented on the basis of the directional bias. Combination and complex strategies can be developed using long and short positions on different options with different strike prices and expiration dates.
Volatility studies are an integral part of option strategies. The value of an option is dependent on the price of the asset, the strike price, volatility, time until expiration, and interest rates. These factors must be examined to select the best option strategy. Software programs and online resources are available to help the investor research option pricing and probability factors.
Hedging and risk management strategies are used by investors concerned with the anticipated volatility of owned assets or securities being purchased. Downside protection is provided in a fashion similar to an insurance policy. Investors are able to maintain ownership and the profit potential of securities while limiting possible losses through the use of financial derivatives.
Manufacturers and suppliers of all kinds use the futures market to buy and sell products and materials. A farmer is able to lock in the sales price of corn through derivative trading. An international corporation can hedge against currency values in the futures market. The types of derivative trades that can be made are virtually unlimited.
Selecting the best strategy for derivative trading begins with a trading system. Risk tolerance and reward expectation must be calculated in advance along with the probability of success. Money management is a key element in any trading system. The strategy selected can be as simple as buying a put or a call. Complex strategies require knowledge, experience, and research to determine the best strategy to achieve the investment objective.