An Overview of 10 Derivative Trading Strategies

Approaching derivative trading without a sound and solid strategy is like trying to steer a boat without a rudder. On the other hand, sticking to a strategy allows for consistency over the long term and reduces the risk of being prone to emotional trading.

Although every derivatives trader eventually develops their own unique approach and style, the following 10 derivative trading strategies make for a good starting point to being your trading journey:

1. Bear Put Strategy

Whether you’re trading gold-cash, GBP/USD, or any other cash derivatives, a CFD trading or a spread betting platform will tell you that financial instruments are all about making the best of every market state, whether it be bearish or bullish. So if you have any reason to believe the financial markets will be going down soon, you could consider the bear put strategy.

In essence, the strategy revolves around making the bear market play out to your advantage. You do this by buying a put on an underlying asset. At the same time, you should also be doing the same move once again (same asset, same expiration month), but at the same time, the strike price should be lower.

What does this achieve? If the market does indeed go down in line with your expectations, this allows you to capitalize on the market trends as well as the price of the asset.

2. Bull Call Spread Strategy

Financial markets can go either up or down, so far so clear. So what do you do when you expect the market trends will shift upwards? You should utilize the bull call spread strategy.

As the name implies, this involves buying a call on the underlying asset, but the story does not end there. In addition, what you should be doing is to also be selling a call on the same underlying asset (the expiration month should also be the same). But doesn’t this sound self-defeating, you may ask? The catch is, that you are going to do so at a higher strike price, which is what makes all the difference.

One of the major advantages of this strategy is that it effectively limits your risk, even though the profit you stand to make is somewhat limited as well. But on the flip side, you’ll never have to worry about losing the entire premium paid in case things don’t go your way.

3. Box Strategy

Now that you know how to capitalize on both bear and bull markets alike, it’s time to step things up a notch and learn to put another spin on it with the box strategy. Also referred to as “long box strategy”, this is a form of arbitrage where a trader buys two spreads at the same time, both the bull call spread and matches it with the bear put spread.

But what does this accomplish, since these moves clearly lie on the opposite end of the spectrum, with the only common ground being their expiration dates and strike prices? The right time to do this is when the spreads are underpriced when compared with their expiration values and that’s how a savvy trader can take advantage of it.

4. Protective Collar Strategy

What does a savvy trader do when the goal is to secure one’s profits without selling their shares? Utilizing the protective collar strategy is the perfect solution for this exact purpose. It’s also a common tactic that brings about some stability when the financial markets are swinging wildly in both directions.

It consists of a long position on an underlying asset, coupled with both a put and a call option at the same time. In essence, this is an options strategy that grants you short-term protection against swingy market volatility at the expense of limiting your profits when the market trends finally do start going up.

5. Covered Call Strategy

Are you holding a long position on an underlying asset and are looking for a low-risk strategy to squeeze out even more profits? Then consider utilizing a covered call strategy. The reason why it’s so popular is because the amount of risk you have to take on is rather minimal, especially compared to some of the other derivative trading strategies out there.

In the worst-case scenario, you’re going to have to sell shares that you own because with this strategy, you put the underlying asset as collateral. This approach to trading works incredibly well if you’re expecting at least a moderately bullish market trend. With lower volatility, the expected returns are greater (and the reverse is true with higher volatility).

In terms of risk vs. reward, your profits will be limited and your losses potentially huge. Therefore, this strategy is best used when the financial markets are somewhat consistent.

6. Long Straddle Options Strategy

Employing a long straddle options strategy is when a trader decides to purchase both a call and a put option with the same variables (same strike price, expiration date, and underlying asset). This is a good way to keep your bases covered.

It’s the optimal way to proceed when you expect significant changes in the market pricing as it relates to the underlying asset. A great example of this is rapid price movements during turbulent times such as elections, protests, etc.

Following this strategy is a good way to not only profit from a big event, but also limit your losses, so it’s considered low-risk. If you’re worried about time decay and expiration dates that could be problematic, this particular strategy is also a solid option. 

7. Long Strangle Options Strategy

Not to be confused the long straddle options strategy we gave an overview of the above, with this one, the trader is looking to purchase a put and a call option with several overlapping variables such as the underlying asset and the maturity. However, these two options have different strike pricing.

Typically, the strike price tends to sit below the call option’s strike price. Much like the strangle strategy you already know, this is the staple move of a trader who uses financial instruments to enter the markets at the right time, which is usually when major movements are expected in the market. The beauty of this strategy is that it can work wonders no matter the direction of the swing.

Compared to straddles, strangles tend to cost less. Technically, the profit potential is limitless when executing this move and you can use it to gain something even when the market is bearish. The more volatile the markets, the more it makes sense to follow this strategy.

With the right strategy, it’s possible to do well even when the markets are bearish.

Source: Pixabay.com

8. The Conversion Reversal Strategy

The conversion reversal strategy can be considered an arbitrage strategy in derivatives, options, and margin trading. It tends to be viewed as a very low-risk way to make some profit under the condition that the options in question are overpriced when put side-by-side with the underlying asset.

As good as this may sound on paper, in practice, spotting opportunities where the conversion reversal strategy could be applied with reasonable returns can be quite challenging. The fact of the matter is, any price discrepancies tend to be filled very quickly.

Worse yet, most brokers tend to charge higher commissions for this type of manoeuver, making it almost impossible to turn a profit with it. While broadening your horizons and knowing your options is always a good idea, amateur traders should probably look to implement other strategies when starting out.

9. Cash And Carry Strategy

Sharing the same name with the popular retail franchise, the cash and carry strategy is about holding a long position, but with a twist. In addition to holding the asset, the trader would also invest in a futures contract short position pertaining to the very same asset.

In this type of trade that’s also referred to as basis trading, the contract delivery date plays an important role, and the asset is held in the process until that point in time. This is for the purpose of covering the obligation.

The strong point of the strategy is that it gives you a window of opportunity to exploit a correction in the mispricing. Typically, this would be when initiating futures or options contracts.

10. Reverse Cash And Carry Strategy

Last but not least, we’ve left a strategy for the end that’s almost the same, but in reverse. When a trader shorts an asset and longs a futures position for that asset is an example of applying this strategy. It’s relatively low-risk and the purpose is to capitalize on an opportunity to generate a profit on the asset’s pricing differences.

However, note that the strategy is only viable in certain situations. For example, it makes sense to employ it when you determine that the future prices are cheap in comparison with the asset’s spot price. In other words, when you will get more from the short sale than the price of the futures contract and whatever costs there are to short it as far as carrying it goes.

Conclusion

As you can see, no strategy is bulletproof and all have their uses in certain situations. Now, it’s up to you to read the market correctly and capitalize on the knowledge you’ve gained.

* Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
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