We are independent & ad-supported. We may earn a commission for purchases made through our links.
Advertiser Disclosure
Our website is an independent, advertising-supported platform. We provide our content free of charge to our readers, and to keep it that way, we rely on revenue generated through advertisements and affiliate partnerships. This means that when you click on certain links on our site and make a purchase, we may earn a commission. Learn more.
How We Make Money
We sustain our operations through affiliate commissions and advertising. If you click on an affiliate link and make a purchase, we may receive a commission from the merchant at no additional cost to you. We also display advertisements on our website, which help generate revenue to support our work and keep our content free for readers. Our editorial team operates independently of our advertising and affiliate partnerships to ensure that our content remains unbiased and focused on providing you with the best information and recommendations based on thorough research and honest evaluations. To remain transparent, we’ve provided a list of our current affiliate partners here.

What are the Pros and Cons of Hedging with Derivatives?

Jim B.
By
Updated May 16, 2024
Our promise to you
SmartCapitalMind is dedicated to creating trustworthy, high-quality content that always prioritizes transparency, integrity, and inclusivity above all else. Our ensure that our content creation and review process includes rigorous fact-checking, evidence-based, and continual updates to ensure accuracy and reliability.

Our Promise to you

Founded in 2002, our company has been a trusted resource for readers seeking informative and engaging content. Our dedication to quality remains unwavering—and will never change. We follow a strict editorial policy, ensuring that our content is authored by highly qualified professionals and edited by subject matter experts. This guarantees that everything we publish is objective, accurate, and trustworthy.

Over the years, we've refined our approach to cover a wide range of topics, providing readers with reliable and practical advice to enhance their knowledge and skills. That's why millions of readers turn to us each year. Join us in celebrating the joy of learning, guided by standards you can trust.

Editorial Standards

At SmartCapitalMind, we are committed to creating content that you can trust. Our editorial process is designed to ensure that every piece of content we publish is accurate, reliable, and informative.

Our team of experienced writers and editors follows a strict set of guidelines to ensure the highest quality content. We conduct thorough research, fact-check all information, and rely on credible sources to back up our claims. Our content is reviewed by subject-matter experts to ensure accuracy and clarity.

We believe in transparency and maintain editorial independence from our advertisers. Our team does not receive direct compensation from advertisers, allowing us to create unbiased content that prioritizes your interests.

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.

SmartCapitalMind is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
Jim B.
By Jim B.
Freelance writer - Jim Beviglia has made a name for himself by writing for national publications and creating his own successful blog. His passion led to a popular book series, which has gained the attention of fans worldwide. With a background in journalism, Beviglia brings his love for storytelling to his writing career where he engages readers with his unique insights.
Discussion Comments
By subway11 — On Aug 28, 2011

I think that with any investment it is important to consider a risk evaluation before you invest. Many of these hedge derivatives might be trendy now but if you don’t understand how the market works and are following the advice of some friends you won’t know when you need to pull out of the investment.

I try to do as much research as I can before I invest, and I only try to invest in things I understand. This way I have more control over my investments. I may not break records with my gains, but I won’t lose my shirt either.

Jim B.
Jim B.
Freelance writer - Jim Beviglia has made a name for himself by writing for national publications and creating his own...
Learn more
SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.

SmartCapitalMind, in your inbox

Our latest articles, guides, and more, delivered daily.