Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-06-15T18:15:25+05:30

Introduction

The price of an option is nothing but an enigma. There are many variables or factors. Some of these factors have known values, while one of the factors has an unknown value. Some of these factors are the current price of the underlying asset, the strike price, the type of option. The time to expiry of the option, the interest rate, and the dividends obtained on the underlying asset all need some more understanding. One of the key factors which cannot be measured or which cannot be known is volatility.

Trading is often based on the simple principle of Risk vs Returns. This means greater the risk, the greater the returns. There are two types of volatility, namely Historical volatility, and Implied Volatility. Historical volatility is the actual volatility of the underlying asset over some time. It may be a month of the year. In the case of implied volatility, the fluctuation of the volatility level is implied by the current price.

Although these two volatilities are present, implied volatility is more relevant. This is simply because implied volatility can reflect the current state of the market. It gives an opportunity, a window of risk, and a chance to assess the risk that is in the future. It is not the same in the case of historical volatility.

One may argue that markets are cyclic in nature, and the patterns may repeat in the future, which is correct to a certain extent. However, the cyclic nature of the market has only been able to predict the time when the market rises, or the market falls. More often than not, they have failed to assess the magnitude of the fall. 

When the times are volatile, various traders follow different strategies for trading. Although beginners stick to ordinary calls or puts (also called plain-vanilla calls or puts), there are different strategies employed by seasoned traders. Some of them are Strangles, Go long, Go short, and Iron Condors. Let us try to briefly understand each one of them and what it stands for. 

Strangle

Strangle is a position taken by a trader when they decide to sell a call option and a put option at the same strike price. This position is taken so that the trader receives the premium from both the short call and the short put option. Of course, to employ this, one must have a very good understanding of the market and an appetite for risk, without which this may not pay off well.

Go Long

Go long is another strategy that is employed by traders who feel that the market’s current position is in a state where it encourages buying. Hence they deploy the strategy of “Buy High and Sell Higher,” Although the position they take in the market may be subjective in nature and can always bring up a question, if it was held for a longer time, the gains would have been more. But ultimately, it is the trader’s call to decide when to sell it and at what price to sell it.

Go Short

Go short is usually a strategy taken by people when they combine the short call position with a long call position and is usually at a higher price. This is known as a bear call spread. There is a lot of speculation involved while dealing with this option as one may settle at a lower price and may lose out a chunk of profit.

When it comes to the Iron Condor strategy, the trader combines a bear call spread with a bull put spread of the same expiration. By doing this, the range in which the trading happens reduces, thereby reducing losses.

Conclusion

Ultimately, these are strategies deployed by different traders that are in line with their trading style. In any case, the probability of incurring a loss is slightly higher than incurring a good profit. However, like all the others, the motive of these traders is to minimize the risk, which is done successfully by them.

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