Derivatives might sound daunting, but they can be powerful financial tools to enhance returns and control risk. If you are brand new to derivatives and want to understand how they work and how they can be used, you have come to the right place. This guide will explain derivative trading strategies and provide you with 7 proven strategies, along with important principles of risk management.
Derivatives 101: A Beginner’s Guide
Essentially, a derivative is a financial contract whose value is based on the value of an underlying asset. The underlying assets can be just about anything, including stocks, commodities, currencies, or even market index futures such as the Nifty. It is somewhat like an insurance policy on your car, as the value of the policy is determined by the car.
The two main types of derivatives you are likely to encounter are:
Options: They provide the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price) on or before a predetermined time (expiration date).
Futures: These are standardized contracts obligating the buyer to buy, and the seller to sell, a specified asset at a predetermined price at a specified time in the future.
Why do traders use derivatives? The most common reasons are for leverage, hedging, and speculation. Leverage allows you to control a lot of any given asset with a relatively small amount of capital. Hedging is used to protect existing investments from unfavorable price movements. Speculation is betting on the future price direction of an asset to make money. If you have questions on how to get started, check out our guide on How to Start Trading in the Derivatives Market, which can provide valuable insights.
The 7 Best Proven Derivative Trading Strategies
Let's start with some of the most effective and simple derivative trading strategies that beginners can use. Always practice using a demo account before putting your capital at stake!
1. Covered Call (Options): Generate Income
What it is: you already own shares of a stock, and you sell (or write) a call option against your shares.
How it works: In the first case (selling or writing the call), you receive a premium for the position. If the stock price stays below the strike price, the option expires worthless, and you keep the option premium. If the stock price is higher than the strike price (assignable event), your shares will be taken away (sold) from you at the strike price.
When to use: When the stock price is going to be static or slightly bullish. It's one of the best ways to earn periodic income from positions you already own.
Pros: Provides income, some downside protection (equal to the premium received).
Cons: Limits potential upside profit if the stock rises significantly.
2. Long Call (Options): Bullish Speculation
What it is: Buying a call option.
How it works: You pay a premium for the right to buy the underlying at the strike price. You make money if the underlying rises significantly above the strike price prior to expiration.
When to use: When you have a strong bullish outlook on a stock or index, and see a significant price increase.
Pros: Limited risk (your max loss is the premium paid), very high leverage, great potential profit.
Cons: High probability that the entire premium will be lost if the price does not move as expected.
3. Long Put (Options): Bearish Speculation/Hedging
What it is: Buying a put option.
How it works: You pay a premium for the right to sell the underlying at the strike purchase price. You make money if the underlying goes down below the strike purchase price, significantly, prior to expiration.
When to use: When you have a strong bearish outlook, or if you just want to hedge an existing long stock position against a downturn.
Pros: Limited risk (your max loss is the premium paid), may protect portfolios.
Cons: High probability that the entire premium will be lost if the price does not move as expected.
4. Protective Put (Options): Portfolio Insurance
What it is: Purchasing a put option on a stock you already own.
How it works: Comparable to buying insurance for your home. If the value of your stock drops, your put option rises in value, offsetting your stock losses.
When to use it: When you are worried about a potential short-term drop in the stock you own, but you don’t want to actually sell it. This is an important hedging method using derivatives.
Pros: It protects your downside, and it gives you peace of mind.
Cons: The premium cost drives down your total return.
5. Bull Call Spread (Options): Moderate Bullish View
What it is: Buying a call option at one strike price, and selling a call option at a higher strike price (same expiration).
How it works: You pay a net debit (premium paid less premium received). You only profit if the stock price rises between the two strike prices. Your profit is limited to (difference between the strikes) – (net debit).
When to use it: When you have a mildly bullish outlook and believe the stock will go up but not tremendously.
Pros: Less capital required and defined risk compared to long calls, much higher probability of success.
Cons: Limited profit potential.
6. Bear Put Spread (Options): Moderate Bearish View
What it is: Buying a put option at one strike price and selling a put option at a lower strike price (same expiration date).
How it works: You will pay a net debit. You can profit if the price of the underlying is 'anywhere' in between the two strikes. Your profit is capped at the difference between strikes minus the net debit.
When to use: When you are moderately bearish and do expect a stock to fall, but not drastically.
Pros: Lower cost and defined risk over a long put, greater chances of success.
Cons: Limited profit potential.
7. Long Futures (Speculation/Directional): Direct Exposure
What it is: You are buying a futures contract that obliges you to buy the underlying asset at a future date, at the specified price.
How it works: You pledge an initial margin. If the price of the underlying asset goes up, the value of your contract increases, and you will profit.
When to use: If you are very sure that an index (like Nifty) or a commodity (like crude oil) will go in an upward direction.
Pros: High leverage, direct exposure to the price movement of your asset.
Cons: Unlimited risk (you can lose more than your original margin), taking a futures position requires strict risk management. If you want to learn more about futures, you may want to learn about Open Interest in Derivatives.
Risk Management: How to Manage Risk?
Executing derivative trading strategies successfully requires proper risk management. If you absorb one idea as a beginner, this is it.
Define your risk tolerance: Before you enter any trade, you must know how much you can potentially part with. Do not risk what you cannot afford to lose.
Position Sizing: Avoid risking your whole trading capital on one trade. Limit each position size to a very small percentage (e.g., 1-2%) of total trading capital.
Use stop-loss orders: For strategies with unlimited risk (e.g., naked futures), don’t forget to always place a stop-loss order to liquidate your position if it moves against you a certain amount.
Understand Leverage: While trades with leverage could lead to larger gains, they could also lead to larger losses. Therefore, be extra careful with any highly leveraged positions.
Diversification (When Possible): While this may not directly apply to an individual derivative trade, you should ensure that your overall portfolio is not over-concentrated.
Ongoing learning and adaptation: The markets are constantly evolving, so continue learning from your trades and adjust your strategies accordingly, and keep up to date. Our blog posts on Fundamental Analysis in Stock Market and Top Technical Analysis Tools could expand your knowledge of derivatives.
Conclusion
Understanding derivatives trading strategies takes time, effort, and disciplined risk management. As a beginner, it's important to focus on the basics and start with simple, defined risk strategies. These 7 accepted strategies are a great entry point to know how to use derivatives for income, speculation, and to hedge.
Education is your best friend in the financial markets, so paper trade as much as possible, read as much as possible, and keep your capital protected. If this is a career or something you sincerely want to learn more about, look at professional courses that offer similar structured learning. For a more in-depth, practical understanding and to master these derivative trading strategies, consider enrolling in NIFM's comprehensive NSE NCFM Derivatives courses and take your knowledge to the next level.
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