Since its birth in the 1980s, derivatives trading has opened up a world of markets for traders who 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?
Derivatives trading strategy is the technique traders use in buying and selling derivative contracts. 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.
In this post, we take a look at derivatives trading. At the end of the article, we provide you with a derivative trading strategy (it’s actually two so it’s derivative trading strategies).
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 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 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).
We have yet to cover options strategies on this website (coming later), but we have touched upon a couple of examples of how they can be combined with equity trading:
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 are contracts between two parties to exchange one another’s cash flow or a variable attached to 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.
Derivatives trading – hedging
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.
Likewise, an oil producer who knows what his production is in 12 months’ time might want to sell some of that production today via derivatives. This is the reason why derivatives saw the day of light in the first place.
Derivatives trading – speculation
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. Most traders use it for speculative purposes, though.
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).
Their hopes of striking it rich are most of the time put to an end after only a short time. The reason why is that the derivatives market is a 100% zero-sum game. Some traders may make money but at the expense of others who have lost money. An open derivatives contract must always have someone both long and short.
To better understand the odds of success (or not), we have summarized the statics for a variety of brokers and how many of their CFD traders that are making money (brokers are required by law to publish :
- 58% of retail traders lose money when trading CFDs with Interactive Brokers.
- 65% of retail investor accounts lose money when trading CFDs with SaxoBank.
- 67% of retail investor accounts lose money when trading CFDs with eToro.
- 71% of retail CFD accounts lose money with CMC.
- 72% of retail CFD accounts lose money with 500Plus.
- 81% of retail investor accounts lose money when trading spread bets in IG
(You can read more about what percentage of traders fail.)
The likelihood of being consistently profitable trading derivatives is quite low, and here’s also 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. Retail traders, and also professional institutional traders, are liable to make cognitive trading biases in trading.
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 longs 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 not optimal, in our opinion, 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.
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.
FAQ derivatives trading
Based on the number of e-mails we get we decided to make a FAQ to better address any issues about the derivatives trading strategy:
What are the main 4 types of derivatives? What are the most common derivatives?
The main four types of derivative contracts are:
- Futures contracts
- Forward contracts
Is derivative trading difficult?
Hell, yes! Anyone telling you otherwise has no clue what they are talking about (or they are snake oil salesmen). Any speculating endeavor about the future is difficult.
What is the most important derivatives trading rule?
We quote the main rule of Nassim Nicholas Taleb’s Barbell Strategy:
Better to miss a zillion opportunities than blow up once.
Most people don’t understand how to handle uncertainty. They shy away from small risks, and without realizing it, they embrace the big, big risk. Businessmen who are consistently successful have the exact opposite attitude: Make all the mistakes you want, just make sure you’re going to be there tomorrow.
When should a person trade in derivatives?
You should ONLY trade when you are a) hedging, or b) speculating with a specific plan.
We don’t recommend speculating under any circumstances if you don’t have a backtested plan! A backtested plan is, of course, not foolproof, but we believe this is the most rational approach in any speculating endeavor. If you are new to trading and backtesting, you might find our backtesting course useful.
Why is derivatives trading risky?
It’s risky because most traders use too much leverage. You’ll be fine if you structure your trading conservatively and have a margin of safety/error. Reread Taleb’s quote above, please.
What is the best derivatives trading platform?
If you’re a retail trader, just like us, we believe Interactive Brokers is the best. We are using both IB and Tradestation, but we believe IB is the best one for derivatives.
Derivatives trading strategy (backtest and example)
Let’s go on to backtest a derivatives trading strategy with strict trading rules and settings.
Derivatives trading strategy backtest number 1
Better to miss a zillion opportunities than blow up once….They shy away from small risks, and without realizing it, they embrace the big, big risk. Businessmen who are consistently successful have the exact opposite attitude: Make all the mistakes you want, just make sure you’re going to be there tomorrow….Don’t invest any energy in bargaining except when the zeros become large. Lose the small games and save your efforts for the big ones.Nassim Nicholas Taleb
To illustrate the usefulness of derivatives and how they can be used, we’ll show you how they can be used as a “tail risk killer” (or at least mitigate it). You don’t want to lose your trading capital, and you don’t want to sell into a panic or be liable for cognitive trading biases.
One way to reduce tail risk exposure is to use derivatives. Nassim Taleb and his partner Mark Spitznagel have been using this for a couple of decades.
The simplest way to use derivatives for hedging is to hedge an equity portfolio. For example, if you have a diversified portfolio of stocks you can simply buy out-of-the-money puts on the S&P 500. A put works exactly like insurance: you have the right, but not an obligation, to sell something at a future date (expiration) at a certain price (strike). If S&P 500 is trading at 4500, you can, for example, sell put options expiring in 6 months with a strike of 4000 (thus you can sell at 4000, which, of course, only makes sense if S&P 500 is below that level).
But any insurance costs money. If you are to roll over every 6 months you must assume that most of the time you lose the entire option premium you are paying (end up worthless). However, when the market suddenly drops a lot, you stand to make windfall profits. But overall, this is a strategy that is inferior to a buy and hold strategy in the long run.
The famous money manager Meb Faber has an ETF that offers tail risk protection based on buying puts. If you included that ETF in your portfolio the results would have been like this:
We have written a separate article about tail risk:
Derivatives trading strategy backtest number 2
Can you make consistent profits by writing (selling) puts? Evidence points out that implied volatility has exceeded realized volatility and thus options are richly prized. Because of this, a strategy that sells puts might offer attractive risk-adjusted returns.
Oleg Bondarenko authored an article a few years back (An Analysis Of Index Option Writing With Monthly And Weekly Rollover) that did a backtest where he sold puts both monthly and weekly from 1990 until 2015.
The table below shows the implied volatility (the main determinant of the price of the options) and the actual volatility:
Is it possible to make money on the volatility difference? Oleg Bondarenko’s backtest showed that the compound return of the put strategy was 10.1% compared to S&P 500’s 9.8%. This is not a major difference, also considering commissions, slippage, and taxes, but the returns came with much lower volatility (10.1% vs 15.2%). Thus, the Sharpe Ratio is much higher (0.67) vs 0.47 for S&P 500. Historical performance should always be evaluated together with trading statistics and metrics.
List of trading strategies
This blog is more than 10 years old (we started in 2012). We have written more than 800 articles that you can read for free – please see our complete list of trading strategies that work. The strategies are an excellent resource to help you get some trading ideas.
We have compiled the Amibroker code and logic in plain English for all these strategies (plain English is for Python trading). If you subscribe, you’ll get the code in this article (plus over 160 other ideas).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
Derivatives Trading Strategy – conclusion
We end the article with some advice:
Any derivatives trading strategy can be a useful trading tool, but used incorrectly it can also be lethal for your capital and portfolio. Use it wisely, and always backtest! Also, keep in mind that you should never trade something you don’t fully understand. Derivatives are most likely a bit more complicated than stocks, for example, and thus you should not trade them unless you both know what you are doing AND you have some indications this is a strategy where you have a trading edge.