Derivatives Trading Strategy — What Is It? (Backtest)

Last Updated on August 28, 2022 by Oddmund Groette

Since its birth in the 1980s, derivatives trading has opened up a world of markets for traders who just want to profit from the price movements of various derivatives. To succeed in this market, you must have a derivatives trading strategy. But what is a derivative?

In the world of financial trading, a derivative is a financial contract that derives its value from the performance of an underlying asset, which can be a commodity, stock, currency, or index. Derivatives trading strategy is the technique traders use in buying and selling derivative contracts.

In this post, we take a look at derivatives trading.

What is a derivative?

In the world of financial trading, a derivative is a financial contract that derives its value from the performance of an underlying asset, which can be a commodity, stock, currency, an index, or an interest rate. The underlying asset’s value keeps changing according to market conditions, and the derivative’s price fluctuates accordingly to reflect the changes.

Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. There are also CFDs (contracts for difference), which are contracts between a broker and a trader to exchange the difference in the price of an underlying asset between the time a trade is opened and the time it is closed. These contracts can be used to trade any number of assets and carry their own risks.

Derivative trading seems to have a long history. In the ancient Greek civilization, Aristotle documented what has been considered the oldest example of a derivative in history — a contract transaction of olives entered into by ancient Greek philosopher Thales. According to the report, Thales made a profit in the exchange.

Derivatives can be used for a number of purposes: they can be used to hedge against price movements, speculate on price movements, or get access to otherwise hard-to-trade assets or markets. Essentially, derivatives are used to move risk (and the accompanying rewards) from the risk-averse to the risk seekers. While derivatives are mostly traded on central exchanges (such as the Chicago Mercantile Exchange) or over-the-counter (OTC) marketplaces, the ones that trade on the OTC markets tend to have a greater risk than the derivatives traded over exchanges.

Types of derivatives

Below is a breakdown of the main types of derivatives:

Futures contracts

Futures are contracts that are traded on an exchange, which gives the parties involved the obligation to buy or sell a given quantity of an asset at a predetermined price at a specified time in the future. Futures are similar to forwards or in fact, an evolution of the latter — futures contracts are standardized and traded on exchanges, so they are subject to a daily settlement procedure.

Options contracts

options give the buyer the right — not an obligation — to buy or sell an asset to the other at a future date at an agreed strike price. There are two types: call option (if it gives the right to buy an asset) and put option (if it gives the right to sell an asset).

Forward contracts

Similar to futures, a forward contract is an agreement to trade an asset at an agreed price on a future date. The contract is settled on the agreed future date when the buyer pays for and receives the asset from the seller at the agreed price. The terms of the contract are privately agreed upon between the parties involved.

Swaps

swaps are contracts between two parties to exchange one another’s cash flow or a variable attached with various assets. There are different types of swaps: interest rate swaps, currency swaps, and commodity swaps.

Contracts for Difference (CFDs)

A CFD is a derivative financial contract that represents an agreement between a broker and a trader to exchange the difference in the price of an underlying asset between the time when a trade is opened and the time when it is closed. There are many online CFD brokers, offering CFDs on almost every available asset. While it is easy to register and trade with them, choose carefully because many are not regulated.

Is derivative trading profitable?

The act of buying and selling derivatives for whatever reason, but especially for speculative purposes, is known as derivative trading. While industry stakeholders, farmers, and producers may be trading derivatives to hedge risks, retail traders and some institutional traders trade the derivative markets to profit from price movements. Some institutional traders also use derivatives, such as options, to hedge their exposure in the equity and bond markets.

For most of the industry stakeholders and institutions that trade to hedge risks, the goal of trading derivatives is not to make profits, but to reduce their risks in other markets, such as the spot commodity market, equity market, or bond market. For example, a farmer who produces wheat may sell wheat futures long before harvest to secure demand for his product and lock in the sale of his product at a good price. Similarly, a trading institution with a huge stock investment may buy stock put options to protect the downside of the investment.

However, the game is different for retail traders who come to the derivative markets to assume risks with the hope of making commensurate profits (aka speculation). Speculation is a zero-sum game. Some traders may make money but at the expense of others who have lost money. The likelihood of being consistently profitable trading derivatives is quite low, and here’s why: the underlying asset’s value keeps changing according to market conditions, as it is exposed to various market sentiments and other political, economic, and social changes. Moreover, some derivative products are poorly structured. An example of derivatives that were flawed in their construction and destructive in their nature are the infamous mortgage-backed securities (MBS) that brought on the subprime mortgage meltdown of 2007 and 2008 — the impact was so huge that it triggered a global recession.

Derivative strategies examples

As we stated above, there are different types of derivative instruments available for trading. But the ones that are easily accessible to retail traders are futures, options, and CFDs. There are strategies that are unique to each derivative market, and there are general strategies that work for all instruments. We will explore the market-specific strategies first and then the general strategies.

Futures-specific trading strategies

These are some strategies that are unique to futures trading:

  • Bull Calendar Spread: With this strategy, you buy and sell futures contracts of the same underlying asset but with different expirations. You take a long position on the near-term expiry and a short position on the long-term expiry because it is expected that the spread will widen in favor of the long so you end up in profit.
  • Bear Calendar Spread: This is the opposite of the bull calendar spread — you take a short position on the short-term contract and a long position on the long-term contract. Here, the expectation is that the spread would widen in favor of short so you end up in profit.

Options-specific trading strategies

Many options strategies are specific for options trading, and here are some examples:

  • Buy Call: Traders buy calls when they are bullish on the underlying with the hope of selling it higher.
  • Buy Put: Traders buy puts when they are bearish on the underlying and hope to buy it at a lower price.
  • Covered Call Strategy: Here, a trader buys an underlying asset in the spot market and sells a call of the same asset. This strategy is used by a trader who has a neutral-bullish bias. This strategy is quite awful because it offers limited rewards with unlimited risks.
  • Married Put Strategy: Here, you buy a put option for stocks you already own or intend to buy. If you are bullish on a stock, you use this strategy to minimize the impact of a fall in prices.

General strategies

These are strategies that traders use in all markets, including equities, CFDs, and futures. There are many strategies around, but the common ones are usually classified into these three categories

  • Trend-following strategies: These are built on the price potential to continue moving in its trend direction. The idea is to capture the big impulse swings in the direction of the trend, so these strategies tend to give huge profits when you manage to get a good trade. However, trend-following strategies tend to have a poor winning rate.
  • Momentum strategies: The strategies in this group tend to take a position when there is an accelerating movement in some direction. It often uses breakouts to capture momentum. An example is Range expansion when you get a fast and strong movement during a day or period that is much larger than what is normal and you buy into the movement.
  • Mean-reversion strategies: These strategies are based on the idea that the price has a long-term average, and it tends to revert to that average anytime it moves significantly away from it. With indicators that show the average price and the overbought/oversold conditions, such as the Bollinger Bands, RSI, and so on, traders take long positions when the price is oversold and go short when the price is overbought.

Derivatives trading strategy (backtest and example)

A backtest of a derivatives trading strategy is coming soon.

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