Trading the Underlying

Overview

One of the ways to trade derivatives is to use derivatives to make a bet on the underlying asset. That is, the trader is not making an evaluation of whether the derivative is fairly priced, but rather using the derivative to structure a trade or trade strategy on the underlying asset.

Directional Bet

A directional bet is one where the trader is placing a bet on the direction of where the asset will be in the future. For example, a trader who believes that the asset will trend up, may decide to buy a call option on the asset. Or if she believes that the asset's price will decrease, she may decide to buy a put option.

Trading the option instead of the underlying gives the trader insurance that if her hypothesis does not play out, she only stands to lose the option premium.

Using options is roughly equivalent to trading a trend stragey. AS an example, a trend trader may place a trade on a asset based on its price being above a given moving average. If the assets price continues to go up, she profits. If the asset price begins to go down and pierces either the moving average in question, or the traders stop price, she gets stopped out. The losses that she takes is in sense equivalent to the option premium show would have spent.

Volatility Bet

As an alternative, a trader may wish to bet on the volatility of the underlying. Because the price of an option depends on the volatility of the underlying, a trader who has a forecast on volatility can structure a trade to try to capture changes in the underlying's volatility.