A Day Trader's Guide To Derivatives, Options And Speculation

My day-to-day trading routine doesn’t generally include keeping track of anything beyond my particular watchlist any tickers that might trip my momentum scanner. This is where I’ve found success, but a lot of the new traders I speak with want a broader view the of trading strategies and financial vehicles available to them.

Given the optimism of this current bull market and the recent launch of bitcoin speculation, that frequently means they want to learn about derivatives like futures, and options.

Broadly, derivatives are any class of financial instrument whose price is dictated by the price of another asset, like a stock, index or commodity. Derivatives themselves are agreements or contracts promising the sale (or purchase) of another asset at a given time, and smart, skilled traders use the price fluctuations of these agreements to make a profit.

Critically, derivatives contracts are assets in and of themselves. As the terms of the derivative become more or less favorable (depending on the terms outlined in the agreement and the price of the underlying asset), traders can sell the contract at any point to confer the rights or obligations outlined in the agreement onto another trader.

In the most general sense, that’s the idea behind derivatives. In practice, each kind of derivative serves a different function, and each works best with a different underlying asset. One thing all derivatives have in common is that they thrive on volatility.

For those new to derivatives, futures contracts might sound the most familiar. Futures contracts are a standard agreement between a buyer and a seller for a particular asset—commonly a stock or commodity—for a predetermined price at a set time. Most futures contracts represent currency and commodities because of their higher relative volatility compared to stocks. Futures contracts that represent equities are popular among pre- and post-market traders wagering on the next day’s opening price.

More common to equity markets are options, which are a bit more complicated than futures due to the the different types of options contracts and the different sides a trader can be on. Essentially options contracts are conditional agreements that are only executable once a stock meets a predetermined price (strike price) before the contract expires.

In the case of call options, the options buyer has the right to buy the contract’s underlying shares once the price has risen above the strike price. In the case of put options, the buyer of the contract has the right to sell the contract’s underlying shares once the price has fallen below the strike price. In either case, the options seller has to sell or buy the shares if the options buyer chooses to execute. However, they also receives a premium on the contract, regardless if it executes.

Other kinds of derivatives, like swaps and forwards, are less popular but function similarly. The main strategy underlying derivatives is an informed wager about price and time.

Take a call option as an example and compare that to outright buying a stock. If you buy a call option on Tesla Inc. TSLA, you likely have a bullish outlook on the stock and believe the price will increase sufficiently before the contract expiration. You paid a premium for the potential of getting the stock at a lower price in the future. If the stock does surpass the strike price, you might make back that premium. If it doesn’t, you will have lost the premium you paid, but that’s all.

Had you bought the Tesla stock outright, you would be liable for whatever gains or loses occur in the stock's price, and you could choose to sell out of your position at any time. However, with the options contract (and with most derivatives) you could choose to sell your option if you don’t feel as confident in the terms and timeframe or if you feel the contract is more valuable that the assets it represents, though other traders will appraise it similarly. You could also hold on to an options contract as a hedge against risk in another position you might be in or against another options contract you might be holding.

These types of options strategies can get very complex, but some traders thrive on anticipating market sentiment. Trading derivatives takes a lot of practice, and it’s not for everybody. I encourage any interested traders to thoroughly study a particular derivative before jumping in.

Disclosure: Warrior Trading is an editorial partner of Benzinga.