Hedging with derivatives is the practice of investors using derivative investments like options or futures to protect against losses by 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 can't be damaged by the poor performance of the security underlying the derivatives contract. Unfortunately, this practice also lessens the potential for the investor to gain profits and also introduces the somewhat unpredictable nature of derivatives into the mix.
Many investors use derivatives, which are financial instruments that allow speculation on a security without actually having to purchase the security itself, as a low-cost alternative to stock investing. The price of a derivatives contract is usually a small percentage of the market price of the underlying security, and it offers more flexibility to the investor for short-term significant profits. While some look to them seeking profits, other investors prefer hedging with derivatives as the best way to use these volatile instruments.
There are several different methods of hedging with derivatives available depending on the type of derivative in question. An investor can use option contracts known as puts to balance the risk of having 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 stock price falls, the put option contract becomes more valuable, meaning the investor can sell it at a premium as a way of buffering losses until the stock rebounds.
Another way that an investor can use hedging with derivatives to benefit himself is through a futures contract. A futures contract stipulates the sale of a specific security at the current market price on some date in the future. Once again, an individual heavily invested in a certain security can use a futures contract as a way to lock in the selling price of that security. This will also prevent against a potential drop in price.
Some drawbacks do exist in hedging with derivatives that an investor must understand. For one, the practice of hedging is essentially a bet against the initial investment. This means that any profit from the initial investment will be mitigated by the loss suffered by the derivative. In addition, prices can move so rapidly that a loss suffered by the hedging derivative can outweigh any gains from the underlying security.