Derivative hedging uses options or futures to protect against losses in an investment portfolio. While it minimizes risk, it also lessens profit potential and introduces unpredictability. Derivatives can be a low-cost alternative to investing in shares, but hedging is essentially a bet against the initial investment and can lead to losses exceeding gains.
Derivative hedging is the practice of investors using derivative investments such as options or futures to protect themselves against losses from other investments in their portfolios. By successfully playing one investment off the other, an investor can keep risk to a minimum. The benefit of hedging with derivatives is that an investor cannot be harmed by the underperformance of the underlying security in the derivative contract. Unfortunately, this practice also lessens the potential for the investor to make a profit and also introduces the somewhat unpredictable nature of derivatives into the mix.
Many investors use derivatives, which are financial instruments that allow you to speculate on a security without having to buy the security itself, as a low-cost alternative to investing in shares. The price of a derivative contract is typically a small percentage of the market price of the underlying security, giving investors more flexibility to earn significant short-term profits. While some consider they are looking for profit, other investors prefer derivative hedging as the best way to utilize these volatile instruments.
There are several different derivative hedging methods available depending on the type of derivative in question. An investor can use option contracts known as puts to balance the risk of owning a significant amount of a certain stock. A put option gives the owner the right to sell 100 shares of an underlying stock at some point in the future. If the share price falls, the put option contract becomes more valuable, meaning the investor can sell it at a premium as a way to cushion losses until the stock recovers.
Another way that an investor can use derivative hedging to profit is through a futures contract. A futures contract stipulates the sale of a specific security at the current market price at some date in the future. Once again, an individual heavily invested in a certain security may use a futures contract as a way to lock in the selling price of that security. This will also prevent a possible drop in price.
There are some drawbacks to hedging with derivatives that an investor should understand. For one thing, the hedging practice is essentially a bet against the initial investment. This means that any gain from the initial investment will be offset by the loss suffered by the derivative. In addition, prices can move so quickly that a loss incurred on the hedging derivative may exceed any gain on the underlying security.
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