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Australian Financial Services (AFS) Licence 246566

Trading a Trend

This lesson will teach you how to buy options to trade a trend.

You should be familiar with the method of selling or buying in the underlying market to trade a downtrend or uptrend, respectively. You may add a stop-loss order to control your maximum loss. If the market reaches the stop-loss your position is closed at a loss.

The chart below shows the profit or loss of a long (through buying) position over a range of market rates. The dotted gray zero line is the break-even point. Anything above the gray line is profit and anything below is a loss. The trader bought in the market at rate A. He will profit if the markets rises and will be stopped-out (red line) if the market falls.

Spot Trades P&L

Buying an option to trade a trend

Through buying a Put or Call option you can profit from a downtrend or uptrend, respectively. The maximum loss when you buy an option is limited to the premium paid at open. You manage your total risk upfront and it cannot be increased during the trade. Your position stays open no matter how the market moves and you do not have to utilise a stop-loss order. Hence, buying an option to trade a trend may be useful in a volatile market where managing risk can be difficult.

Trading an upward trend

To trade an upward market trend (uptrend), you can either go long (through buying) in the underlying market or buy a Call option. The charts below shows you the difference between the two trades.

 

Spot trade vs. Call trade

If the market rises, both the buy trade in the underlying and the Call option will bring a profit, and if the market falls, both will bring a loss. However, the Call option will never get stopped-out and loss is limited to the premium paid at open.

Trading a downward trend

To trade a downward market trend (downtrend), you can either go short (through selling) in the underlying market or buy a Put option. The charts below shows you the difference between the two trades.

 

Sell trade vs Put Option

If the market falls, both the sell trade in the underlying and the Put option will bring a profit, and if the market rises, both will bring a loss. However, the Put option will never get stopped-out and loss is limited to the premium paid at open.

In summary: 

 

Buy Option vs Spot Trade

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