What are Different Strategies for F&O Trading?

Futures and options are not just about trading and hedging but also simple and hybrid strategies Futures and options strategies are at the core of derivatives and there are a variety of F&O trading strategies that one can safely and effectively apply. We will first look at some of the best future strategies and then turn to the best option strategy under the conditions. Here is a future option strategy primer.

Different Strategies for F&O Trading

We will divide our discussion into two parts. In Part 1 we will look at futures strategy with a focus on how to use futures as per the need. Futures strategy is relatively simpler and plain vanilla. In the second half, we get to the options strategy. Being asymmetric products, options strategies can be a lot more complex.

Futures strategies

Let us look at four future strategy pieces here. Futures strategy is not necessarily a combination but it can be plain vanilla and simple also. Futures strategy can also be unidirectional.

• The first plain vanilla futures strategy is Going long. This is the most basic method which entails buying a futures contract. Normally, you buy a futures contract expecting the contract to rise in price before the expiration. Remember, this future strategy is speculative and is opportunistic to make money when the price of the underlying goes up. This futures strategy offers a leveraged return on the underlying asset’s rise, so the expectation is bullish.
• The second plain vanilla futures strategy is Going Short. This is another basic approach that entails selling a futures contract. Normally, you sell futures contracts expecting the contract to fall in price before the expiration. Remember, this short futures strategy is speculative and is opportunistic to make money when the price of the underlying goes down. Going Short strategy offers a leveraged return on the underlying asset’s fall, so the expectation is strongly bearish.
• The third but slightly more sophisticated strategy is the bull calendar spread involving two sets of futures. Bull calendar spread is a futures strategy where the trader buys and sells contracts on the same underlying asset but with different expirations. In a bull calendar spread strategy, typically, the trader goes long on near month futures and short on mid-month or far-month futures. The goal of this future strategy is to see the spread widen in favor of the long contract. Here the best is not on the level of the index but the spread widening or narrowing.
• The fourth and last futures strategy is the bear calendar spread. In a bear calendar spread strategy, the trader goes short on near month futures and long on mid-month or far-month futures. The goal of this future strategy is to see the spread widen in favor of the long contract. Here again, the bet is not on the level of the index but the spread widening or narrowing.

These four encompass the key to future strategies. There is also arbitrage but that also has a cash market component to it.

Options strategies

We now move to the options strategy. Remember, options are asymmetric in the sense that the buyer has right but no obligation and the seller has obligation but no right. Here is some popular and commonly used options strategy.

1. Protective Put strategy typically assumes that you have purchased a stock to hold from a long-term perspective. However, you are worried about downside risks as the recent news flows raise the possibility of the price correcting temporarily. What do you do? You don’t want to exit the stock as you have long-term faith in the stock. The options strategy you can apply is the “Protective Put” strategy. In a protective put, you hold on to your cash market positions but simultaneously buy a lower put option (right to sell). Thus, your maximum loss is limited by the put option.
2. Covered Call strategy is applicable when you bought a stock, which later corrects and you want to reduce your cost of holdings. The covered call is not exactly a limited risk options strategy. The covered call is used to reduce the cost of holding a stock. Instead of letting the investment idle, this options strategy sells higher call options, earns the premium, and reduces the cost of holding the stock. That is surely better than just sitting and watching your stock go down. As well as make some money out of it.
3. The Collar is an options strategy that combines the protective put and covered call discussed above. In the covered call strategy, the downside risk is open. The collar does two things. It plugs the downside risk of a covered call. At the same time, this options strategy also reduces the cost of the put option by selling a higher call option. However, there are 3 phases to the strategy. First, you buy the stock. Secondly, you buy a lower put option, and finally, you sell a higher call option. All this entails a cost, so take that into account.
4. Straddle is a volatile options strategy. The straddle involves buying two options of the same strike prices and same maturity. You can belong straddle or short straddle. A long straddle is created by buying a call and a put option of the same strike and same expiry whereas a short straddle sells a call and a put option of the same strike and same expiry. A long straddle is profitable when the stock is highly volatile either on the upside or on the downside. You need to cover double premiums.
5. The Strangle options strategy is a variant of the straddle. The strangle involves two options of different strike prices but the same maturity. A long strangle buys a higher strike call and a lower strike put option of the same expiry whereas a short strangle sells a higher strike call and a lower strike put option of the same expiry. By widening the risk, writers are more willing to write strangles than straddles.
6. Butterfly spread options strategy is a short straddle with limited losses. The butterfly spread is a closed strategy but there are 4 legs to initiation of the Butterfly Spread and 4 legs to closure. That will add to the costs of the strategy when you consider the transaction and statutory costs. Hence butterfly spread is sparingly used.
7. Bull Call Spread options strategy is a moderately bullish strategy where you buy a lower strike call option and sell a higher strike call of the same expiry. This is a vertical spread contract, where the maximum profit and the maximum loss are defined and hence it is a closed strategy. It is to be only used when you are moderately bullish.
8. Bear Put spread is a moderately bearish strategy and is the reverse of the bull call spread. In bear put spread you buy a higher strike put option and sell a lower strike put option of the same expiry. Like in any vertical spread, the maximum profit and the maximum loss are fixed and hence it is a closed strategy. It is to be used only when moderately bearish.

There are a lot more variants but these encompass the most important of the options strategy universe available.

Who are the participants in the derivatives market?

Broadly, there are 3 types of participants in the futures and options market. Let us have a quick look at each of them.

• The first category of participants in the hedgers who are in the derivatives market to protect and reduce risk. Hedging is an act, whereby an investor seeks to protect a position or anticipated position in the spot market. Hedging is only done where there is an underlying position. It is done by using an opposite position in derivatives. If you have a buy position exposure, you have to create a sell position in derivatives and vice-versa. Hedging entails a cost.
• Speculators are traders or you can even call them punters. They are useful as they provide depth and breadth to the markets. Speculators do not have any risk to hedge. They take on a high level of risk in anticipation of profits.
• Arbitrageurs are crucial institutional derivatives market participants. Arbitrage gives risk-free profits. Some traders participate in the market for obtaining risk-free profits. They do so by simultaneously buying and selling financial instruments like stocks futures in different markets. For example, one can always sell a stock on the NSE and buy simultaneously back on the BSE. But these arbitrage opportunities have almost vanished. The more popular is cash-futures arbitrage which is on the spread between spot and futures.

What are the different types of derivatives contracts?

There are a whole lot of derivative contracts available and the list is endless. Here is an example of some popular derivatives contracts. They include stock futures, index futures, stock options, index options, VIX futures, interest rate futures, currency futures, currency options, cross-currency options, commodity futures, commodity options, interest rate swaps, currency swaps, etc.

Frequently Asked Questions

Can I create my own strategies?

Yes you can create your own strategies but you need expertise and the ability to manage risk and monitor these strategies. For starters it is better to restrict to plain vanilla strategies or those that are offered by brokers on their trading platforms as a combination.

Are there any risk free strategies?

Arbitrage is a risk-free strategies. However, by definition, all trades and strategies in the F&O market have some element of risk involved.